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Saturday, May 23, 2009

Don't Get Carried Away Now!

As Paul Krugman recently pointed out, one of the central points they made in the latest IMF World Economic Outlook was that recessions caused by financial crises tend to get resolved on the back of export-lead booms, with countries normally emerging from the crisis with a positive trade balance of over 3 percent of GDP. The reason for this is simple, since consumers are so laden-down with debt from the boom period, they are naturally more obsessed with saving than borrowing during the initial crisis aftermath. So much then for the typical crisis, and the typical exit. But musing on this point lead Krugman to an additional, rather disturbing, conclusion: since the present financial crisis is truly global in its reach, the habitual exit route to recovery will only work after we are able to identify another planet to send all those exports to (shades of Startreck IV). The joke may seem a rather exaggerated one, in poor taste even, but behind it there lies a little bit more than a grain of truth.

But not everywhere is gloom and doom at the moment, and on the other side of the world they woke up reeling from different kind of bounce last Monday morning, on learning that India’s outgoing government had been not only been re-elected, but had been thrust back into power on a much more stable basis. And that was not the only pleasant surprise in store for those reading their morning newspapers in London, Madrid or New York, since India's main stock index - the Sensex - shot up as much as 17% during early trading on receiving the news, while the rupee also surged sharply. So just one more time we find ourselves faced with the prospect of living in a rather divided world, where on one side we have growing and deepening pessimism, while on the other we see a burst of optimism, with someone, somewhere, getting a massive dose of that "let a thousand green shoots bloom" kinda feeling. Perhaps we should ask ourselves whether there is any connection?

Well, and to cut the long story short, yes there is, and the connection has a name, and it's called sentiment. Indeed sentiment is precisely why the recent (and highly controversial) US bank stress tests were so important. Their real significance was not for any relevance they may have from a US banking point of view (which was, of course, highly contested), but for the reassurance they can give market participants that there will not be another financial explosion in the United States (as opposed to a protracted recession, and long slow recovery), or put another way, to show the days of "safe haven" investing are now over. Risk is about to make a comeback, and the only question is where?

Which brings us straight back to all that earlier talk of coupling, recoupling, decoupling, and uncoupling which we saw so much of a year or so ago (or to Decoupling 2.0, as the Economist calls it). And to the world as we knew it before the the demise of Lehmann brothers, where commodity prices were booming like there was no tomorrow on the one hand, while credit- and housing-markets markets were steadily melting down in the developed economies on the other, where growth was being clocked up in many emerging economies at ever accelerating rates, while the only "shoots" we could see on the horizon in the US, Europe and Japan were those of burgeoining recessions.

The point to note here is not just that a significant group of investors and their fund managers spent the better part of 2008 busily adapting their behaviour to changed conditions in the US, Europe and Japan, but rather that a very novel set of conditions began to emerge, as the credit crunch worked its way forward and property markets drifted off into stagnation in one OECD economy after another. Just as they were finally announcing closing time in the gardens of the West almost overnight it started "raining money" in one emerging economy after another - as foreign exchange came flooding in, and the really hard problem for governments and central banks to solve seemed to be not how to attract funding, but rather how to avoid receiving an excess of it. Thailand even attained a certain notoriety by imposing capital controls with the explicit objective of discouraging funds not from leaving but from entering the country.

Then suddenly things moved on, and day became night just as quickly as night had become day as one fund flow after another reversed course, and the money disappeared just as quickly as it had arrived. Behind this second credit crunch lay an ongoing wave of emerging-market central bank tightening (during which Banco Central do Brasil deservedly earned its spurs as the Bundesbank of Latin America) with the consequence that one emerging economy after another began to wilt under the twin strain of stringent monetary policy and sharply rising inflation. Thus the boom "peaked" in July (when oil prices were at their highest), and momentum was already disapearing when the hammer blow was finally dealt by the decision to let Lehman Brothers fall in late September. By November all those previous positive expectations were being sharply revised down, with the IMF making an initial cut in its global growth estimate for 2009 - to 2.2 percent from the 3.7 percent projected for 2008. The World Bank went even further, and by early December was projecting that world trade would fall in 2009 for the first time since 1982, with capital flows to developing countries being expected to plunge by around 50 percent. By March 2009 they were estimating that the volume of world trade, which had grown by 9.8 percent in 2006 and by 6.2 percent in 2007, was even likely to fall by 9 percent this year.

Having said this, and while fully recognising that the future is never an exact rerun of the past - and especially not the most recent past - given that emerging economies have been the key engines of global growth over the last five years, is there any really compelling reason for believing they won't continue to be over the next five? Could we not draw the conclusion that what was "unsustainable" was not the solid trend growth which we were observing between 2002 and 2007, but rather the excess pressure and overheating to which the key EM economies were subjected after the summer of 2007? And if that is the case, might it not be that the "planet" we need to find to do all that much needed exporting to isn't so far away after all, but right here on this earth, and directly under our noses, in the shape of a growing band of successful emerging economies.

According to IMF data, the so called BRIC countries actually accounted for nearly half of global growth in 2008 - China alone accounted for a quarter, and Brazil, India and Russia were responsible for another quarter. All-in-all, the emerging and developing countries combined accounted for about two-thirds of global growth (as measured using PPP adjusted exchange rates) . Furthermore, and most significantly, the IMF notes that these economies “account for more than 90 per cent of the rise in consumption of oil products and metals and 80 per cent of the rise in consumption of grains since 2002”.

But behind the recent emerging market phenomenon what we have is not only a newly emerging growth rate differential, since alongside this there is also alarge scale and ongoing currency re-alignment taking place, a realignment driven, as it happens, by those very same growth rate differentials. The consequential rapid and dramatic rise in dollar GDP values (produced by the combination of strong growth and a declining dollar) has meant that a slow but steady convergence in global living standards - at least in the cases of those economies who have been experiencing the strongest acceleration - has been taking place, and at a much more rapid pace than anyone could possibly have dreamed of back in the 1990s, even if the long term strategic importance of this has been masked by the recent collapse in commodity prices and the downward slide in emerging stocks and currencies associated with the post-Lehman risk appetite hangover. Which is why, yet one more time, that simple issue of sentiment is all important, or using the expession popularised by Keynes "animal spirits".

Carry On Trading

But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world's key central banks, has so reduced interest rates that they are now running only marginally above the zero percent "lower bound", and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.

In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, all that liquidity provision is very likely to exit the first world looking for better yield prospects, and where better to go than to to look for it than those "high yield" emerging market economies.

The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan pumped massive liquidity straight into countries like New Zealand and Australia during its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.

Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations whose interest rates are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like India, Brazil, Hungary, Indonesia, South Africa, Turkey, Chile and Peru - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would run like this: you borrow U.S. dollars at the three-month London interbank offered rate of (say) 1.13% and use the proceeds to simply buy Brazilian real, leaving the proceeds in a bank to earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - under the assumption that the exchange rate between the two currencies remains stable, but the real, of course, is appreciating against the dollar.

Other options which immediately spring to mind are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) or Russia (12 percent). And the cost of borrowing is steadily falling - overnight euro denominated inter-bank loans hit 0.56 percent last week, down from 3.05 percent six months ago after recent moves by the European Central Bank to cut interest rates and pump liquidity into the banking system. The London interbank offered rate, or Libor, for overnight loans in dollars is thus down to 0.22 percent from 0.4 percent in November. And while the ECB provides the liquidity, the EU Commission and the IMF provide the institutional guarantees which - in the cases of countries like Hungary or Romania - mean that even is such lending is not completely free from default risk, they are at least very well hedged.

Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among the trades which offeri investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain around 10 percent over the next three months (rising to 260 from around 285 to the euro when they wrote). Investors should also sell the dollar against the Turkish lira and buy the ruble against the dollar-euro basket, according to their recommendations.

And it isn't only Deutsche Bank who are actively promoting the trade at the moment, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. John Normand, head of global currency strategy at JPMorgan, is forecasting a strong surge in long term carry trading as the recovery gains traction. Long trading, he says, is decidedly "underweight" at this point. Long carry trade positions held by Japanese margin traders, betting on gains in the higher-yielding currencies, peaked at $60 billion last July, according to Normand. They were liquidated completely by February, and have subsequently increased to around one third of the previous value (or $20 billion). “Only Japanese margin traders and dedicated currency managers appear to have reinstated longs in carry,” Normand says. “Their exposures are only near long-term averages.”

And Barclays joined the pack this week stating that Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” for investors returning to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the USD may now be headed down a path which is already well-trodden by the Japanese yen.

India on The Up and Up.

But some of these trades are much riskier than others. Many of the countries in Eastern Europe who currently offer the highest yields are also subject to IMF bailout programmes, so they are with good reason called "risky assets". But others look a lot safer. Take India for example. As Reserve Bank of Indian Governor Duvvuri Subbarao stressed only last week, India’s “modest” dependence on exports will certainly help the economy weather the current global recession and even stage a modest recovery later this year. Of course, "modest" is a relative term, since even during the depths of the crisis India managed to maintain a year on year growth rate of 5.3 percent (Q4 2008), and indeed as Duvvuri stresses, apart from the limited export dependence, India's financial system had virtually no exposure to any kind of "toxic asset".

As mentioned above, the rupee rose 4.9 percent this week to 47.125 per dollar in Mumbai, its biggest weekly advance since March 1996, while the Sensex index rallied 14 percent for its biggest weekly gain since 1992.

And, just to add to the collective joy, even as Indian Prime Minister Manmohan Singh began his second term, and stock markets soared, analysts were busy rubbing their hands with enthusiasm at the prospect that the new government might set a record for selling off state assets, and thus begin to address what everyone is agreed is now India's outsanding challenge: reducing the fiscal deficit.

Singh, it seems, could sell-off anything up to $20 billion of state assets over the next five years as he tries to reduce the central govenment budget shortfall which is currently running at more than double the government target - it reached 6 percent of gross domestic product in the year ended March 31, well beyond the 2.5 percent government target. The prospect of a wider budget gap prompted Standard & Poor’s to say in February that India’s spending plans were “not sustainable” and threaten that the country's credit rating could be cut again if finances worsen. But just by raising 100 billion rupees from share sales and initial public offerings in the current financial year would reduce the fiscal deficit by an estimated quarter-point, at the stroke of a pen, as it were. And there is evidently plenty more to come from this department.

As a result of the changed perception that the new Indian government will now - and especially with the elections and the worst of the global crisis behind it - seriously start to address the fiscal deficit situation, both S&P and Moody’s Investors Service, have busied themselves emphasising just how the outcome gives India's government a chance to improve its fiscal situation. The poll result gives the government more “political space” to sell stakes in state-run companies and improve revenue, according to Moody’s senior analyst Aninda Mitra, while S&P’s director of sovereign ratings Takahira Ogawa commented that the result means “there is a possibility for the government to implement various measures to reform for further expansion of the economy and for the fiscal consolidation.”

So off and up we go, towards that ever so virtuous circle of better credit ratings, lower interest rates, rising currency values, and ever higher headline GDP growth, which of course helps bring down the fiscal deficit, which helps improve the credit rateing outlook, which helps... oh, well, you know.

And it isn't only India which is exciting investors at the moment. Brazil's central bank President Henrique Meirelles went so far as to warn this week against an “excess of euphoria” in the currency market, implicitly suggesting the bank may engage in renewed dollar purchases to try to slow down the latest three-month rally in the real. The central bank began buying dollars on May 8, and Meirelles’s latest are evidently upping the level of verbal intervention. The real has now climbed 20.5 percent since March 2, the biggest advance among the six most-traded currencies in Latin America, as prices on the country’s commodity exports rebounded and investor demand for emerging-market assets has grown. The currency is up 14 percent this year, more than any other of the 16 major currencies except for South Africa’s rand, reversing the 33 percent drop in the last five months of 2008.

Carry Me Home

Despite a number of outsanding worries about the emerging economies in Eastern Europe, the general idea that countries like India, Brazil, Turkey, Chile, Peru etc are firmly at the top of the list of the economies where current growth conditions are generally favorable seems essentially sound. Additionally, if this sort of argument has any validity at all it is bound to have implications for what is sure to be one of the key problems we will face during the next global upturn: what to do with the financial architecture which we have inherited from the original Bretton Woods agreement (or Bretton Woods II as some like to call it).

The limitations of the current financial architecture have become only too apparent during the present recession, since with both the Eurozone and the US economies contracting at the same time, the currency see-saw between the dollar and the euro has failed to provide any adequate form of automatic stabiliser. And since Japan's economy is in an even more parlous state -deep in recession, and desperate for exports - having to live with a yen-dollar parity which is at levels not seen since the mid 1990s can hardly be fun. This has lead some analysts to start to talk of a new and enhanced role for China's currency, the yuan, in any architectural reform we may initiate. But obviously, beyond the yuan we should also be thinking about the real and the rupee. However,I would like to suggest the problem we now face is a much broader one than simply deciding which currencies should be in the central bank reserve basket, and it concerns the central issue of how to conduct monetary policy in an age of global capital flows. During the last boom, comparatively small open economies like Iceland and New Zealand were on this receiving end, but this time round we face the truly daunting prospect of having global giants thrust into the same position, while the USD gets pinned to the floor, just as the Japanese yen was previously.

The problem is evidenty a structural one. The euro hit 1:40 to the USD on Friday (at a time when Europe's economies are in deeper recession than the US one is), while - as I said - the Brazilian central bank President felt the need to come out and warn against an “excess of euphoria” in the local currency market following an 18% rise in the real over 3 months. Officially, the euro surged as a result of news that the US might receive a downgrade on its AAA credit rating, but this justification hardly bears examination, given that around half of the eurozone economies could be in the same situation. Obviously currency traders live in a world where the most important thing is to "best guess" what the guy next to you is liable to do next, and in this sense the rumour could have played its part, but the real underlying reason for the sudden shift in parities is the return in sentiment we have been seeing since early May, and the massive and cheap liquidity which is on offer in New York.

Of course, the impact spreads far beyond Delhi and Rio. Turkey’s lira is also well up - and has now advanced 10 percent over the last three months - while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency during the same period.

All good "carry" punts these, with Turkey’s benchmark interest rate standing at 9.25 percent, and Brazil’s rate of 10.25 percent. Even the ruble is up sharply, just as Russia's economy struggles to handle the rapidly growing loan default rates. The currency climbed to a four-month high against the dollar on Friday, making for its longest run of weekly gains in almost two years, hitting 31.0887 per dollar at one point, its strongest level since Jan. 12. The ruble was up 3.2 percent on the week - closing with its sixth weekly advance and extending its longest rally since September 2007 - and has risen 16 percent since the end of January. Russia's central bank has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets. The basic point here is that carry trade players can leverage interest rate differentials and benefit from the changes in currency valuation that these very trades (along with those made by other participants) produce. So all of this is truly win-win for those who play the game, until, that is, it isn't.

Not all of this is preoccupying - far from it, since the issues arising are in many ways related to the problem I started this article with: namely, who it is who will run the trade and current account deficits and do the necessary consuming, to make all those export-lead recoveries (even in China, please note) possible. Evidently the core problem generated during the last business cycle was associated with the size of the imbalances it threw up, and the impact on liquidity and asset prices that these imbalances had. If I am right in the analysis presented here, then we are all on the point of generating a further, and certainly much larger, set of such imbalances as we let the process rip in the uncordinated and unrestrained fashion we are doing. As you set the problem up, so it will fall. Floating Brazil and India is a very attractive and very desireable proposition. Consumers in those countries can certainly take on and sustain more leveraging. The two countries can even to some extent support external deficits as they develop. But they need to do this in a balanced way, an they do not need distortions. The world does not need more Latvias, Estonias, Irelands or Spains (let alone Icelands, and let alone of the size of a Brazil or an India). So policy decisions are now urgently needed to impose measures and structures which help avoid a repeat of the same in what is now a very imminent future. And despite all the talk of reform, very little has been done in practice. Talk of "tax havens" and the like sounds nice, and is attractive to voters, but all this is on the margin of things. What we need is global architectural reform, and policy coordination at the central bank, and bank regulation level, not to stop the capital flows, but to find a more sophistocated way of managing them.

Wednesday, May 20, 2009

Is Hungary Set To Become The New Iceland?

Iceland, why on earth Iceland? Well, the issue I have in mind concerns the independence and viability of central bank monetary policy (especially in a small open economy like Hungary's) and the role interest rates, and investor sentiment, and yield differentials, and oh yes, I almost forgot, that notorious vehicle so beloved by investors the "carry trade" in producing a situation where financial dynamics get really out of hand.

In a visionary paper given at the International Conference of Commercial Bank Economists (held in Madrid, July 2007) - entitled The Global Financial Accelerator and the role of International Credit Agencies - the Danish economist Carsten Valgreen argued the following:
The choice major countries have made in the classical trilemma: ie, Free movements of capital and floating exchange rates – has left room for independent monetary policy. But will it continue to be so? This is not as obvious as it may seem. Legally central banks have monopolies on the issuance of money in a territory. However, as international capital flows are freed, as assets are becoming easier to use as collateral for creating new money and as money is inherently intangible, monetary transactions with important implications for the real economy in a territory can increasingly take place beyond the control of the central bank. This implies that central banks are losing control over monetary conditions in a broad sense. The new thing – this paper will argue – is that we are increasingly starting to see the loss of monetary control in economies with stable non-inflationary monetary policies. This is especially the case in small open advanced – or semi-advanced – economies. And it is happening in fixed exchange rate regimes and floating regimes alike.
Interestingly enough, Valgreen chose as his paradigmatic examples of central bank loss of control over monetary policy the cases of Iceland and Latvia. Equally today we could add the name of Hungary to our list. As Valgreen argued (and this remember, before the sub prime blow-out):
It is no accident that the two examples are small open economies with liberalised financial markets. Being small makes the global financial markets matter more. A country such as Iceland will be the first to notice that the agenda for monetary policy has changed, as the current and capital accounts are naturally very large and important for the economy. However, this is more of a reason to study its experiences carefully, as they might show something of what is in store for larger economies over the next decade.
So the issue really is, does the Hungarian National Bank continue to control monetary policy in any meaningful sense, or is it reduced to responding to events elsewhere? And does the Hungarian government have any effective tool left with which to fight this crisis? But getting ahead of ourselves and going too far into all this, let's step back a bit, and take a longer look at the Hungarian economy, just to set the scene.

The IMF and the EU Agree To A Larger Deficit

The International Monetary Fund and the European Union has now approved Hungary's request for a larger budget deficit this year, thus giving the government marginally more room for manoeuvre in the face of the very severe contraction in GDP. The government is now going to be authorised to aim for a 3.9 percent of gross domestic product shortfall, as compared with the earlier 2.9 percent objective, according to Finance Minister Peter Oszko. The government have also revised their forecasts, and expects the Hungarian economy to shrink by 6.7 percent this year, the most since 1991, a revision from the earlier 6 percent forecast. Hungary was the first EU member to arrange a 20 billion IMF-led bailout last year, lining up 20 billion euros in a bid to avert a default after investment and credit to eastern Europe dried up. The country then pledged to keep its budget deficit under control to qualify for the loan.

The question is, is this good news or bad news? Evidently the decision not to strangle the government budget is welcome (we are in danger of a contraction that feed on itself here, since with external demand at very low levels, applying 9.5% interest rates and fiscal tightening means the economy can simply fall into a downward spiral). But in the braoder context the news is not good. The IMF and the EU have cut Hungary some more slack simply because the ferocity of the slump in output is worse then any previously imagined, and things are now going to get worse, not better. Which made it rather strange to read in Bloomberg this morning that Finance Minister Peter Oszko has announced the government is to consider selling foreign-currency denominated bonds this year in order to take advantage of rising investor confidence. We are on very dangerous gound indeed here gentlemen! I mean, whatever happened to once bitten twice shy. According to Bloomberg:
Foreign-currency borrowing, along with slower growth, a wider budget deficit and higher government debt than elsewhere in eastern Europeraised concern about Hungary’s ability to repay its debt lastyear......IMF and EU officials this week approved Hungary’s plan torun a wider budget deficit this year and next than earlier targeted....
So what exactly has changed? According to the latest data growth is now even slower than before (or rather the contraction is sharper), the budget deficit and gross government debt are both pointing up again, and the only (vaguely) "good" news is that living standards are falling so fast that the trade balance is improving, and with it the current account deficit. But the government debt dynamics are not the same as the external trade one, and things are getting worse, not better, which makes you wonder what all the optimisim is about? In their recent stress testing exercise the Hungarian Government Debt Management Agency suggested the debt path was sustainable (see much more below on this), but in order to offer this assurance they assumed an average growth rate of GDP of 3% 2013 - 2020 even in their worst case scenario! . My estimate is a much more sobre one, and that is, with declining and ageing population to think about - the Hungarian ecenomy will be lucky to average 1% growth over the above time horizon (more justification on this below). So as far as I can see Hungary's public debt dynamics are still set on a clearly unsustainable path.

Then you need to take into account how you have a 9.5% central bank benchmark interest rate going into a 6% percent plus GDPcontraction (with inflation around 3%), so what are people thinking about? This policy mix doesn't work, and it won't. If you lower the interest rates to support the economy, the forint crashes, and with it the balance sheet of all those households still holding CHF denominated mortgages in their portfolio. Hungary is clearly caught between the proverbial rock and the hard place.

And what's more, this policy mix is leading to all sorts of distortions. Hence the reference in the title of this post to Iceland, since Iceland's problems precisely got out of hand, due to the "juiciness" of the trade their domestic interest rate yield differential offered. Viz a recent Deustche Bank report which specifically recommended buying HUF denominated assets, due to the yield differential.
Currency deals that profit from the difference in interest rates globally are returning to favor on speculation the worst of the creditcrisis may be over, spurring investors to buy eastern European assets,Deutsche Bank AG said.The Russian ruble, Hungarian forint and Turkish lira offer investorsthe best returns in the next two to three months thanks to the highestrates in the region, said Angus Halkett, a strategist at Deutsche Bankin London.The so-called carry trade, in which investors borrow in currencieswith low interest rates to buy higher-yielding assets, helped theforint and lira surge to record highs last year before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets.
Perhaps people should reflect a little more on the significance of those final few words: "before the collapse of Lehman Brothers Holdings Inc. prompted investors to sell riskier assets".

This is what is known as the "carry" trade, and it works like this. Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations with interest rates which are often in double figures.Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia which collectively rosee around 8% from March 20 to April 10, the biggest three-week gain since atleast 1999 for such carry trades, according to data compiled by Bloomberg . A straightforward carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating. Now all of this can present a big problem for a number of CEE economies, because:

Turkey’s key interest rate is 9.25 percent, Hungary’s is 9.5 percent and Russia’s 12 percent. The cost of borrowing in euros overnightbetween banks reached 0.56 percent yesterday from 3.05 percent sixmonths ago as the European Central Bank began cutting interest rates and pledges of international aid allayed concern the global slowdownwould worsen. The London interbank offered rate, or Libor, forovernight loans in dollars fell to 0.22 percent from 0.4 percent inNovember as the U.S. government and the Federal Reserve spent, lentorcommitted $12.8 trillion to stem the longest recession since the1930s.

So basically, "Big Ben's" US bailout is fuelling specualtion on Hungarian debt!

And don't miss this point from the Bloomberg article:
Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said.
And it isn't only Deutsche Bank, Goldman Sachs recommended on April 3 that investors use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles.

We can see some of this impact in the German ZEW investor sentiment index. As can be seen, something interesting is happening somewhere, even if it is not immediately evident where. As Solow would have said, "I can see evidence for improved investor sentiment everywhere, except in the real economies".

So, come on everyone, off you go to Monte Carlo, and place your bets. But meanwhile, remember, in Hungary at least, the most notable phenomena are the growing unemployment and the way the bad loans pile up, even as the Hungarian economy tanks! Basically, the all the evidence now points to the fact that IMF and the EU urgently need a rethink about how they are going about things, but this is beyond the scope of the present post.

"Hungarian lenders face an increase in non-performing loans, which will contribute to “substantially deteriorating” profits for the country’s financial system, central bank Vice President Julia Kiraly said. The whole banking system, which is stable with adequate liquidity, may end up with “negative profit” this year and some lenders need to strengthen their capacity to resist shocks, Kiraly said at a conference in Budapest today."

The Fundamentals, All The Fundamentals, And Only The Fundamentals

Horrid GDP Data

The decision to widen the deficit allowance slightly is not that surprising when you take into account that Hungary's gross domestic product dropped by 5.8% year on year in the first quarter of 2009. The figure was announced by the statistics office last Friday and followed a decline of 2.6% in the last three months of 2008.

Quarter on quarter there was a 2.3% GDP decline, (down from 1.5% contraction in the fourth quarter) which means the economy was shrinking at a 9.2 percent annualised rate, quite sharp, but far from being one of the worst cases in the EU. What makes the Hungarian recession rather different is the way it has been lingering in the air since the initial "correction" in 2006, and is now becoming protracted since this was the fourth consecutive quarter when quarter on quarter growth was negative, and it is hardly likely to be the last.

Household consumption is in continuos decline (see retail sales data below), real wages are falling, and the lack of internal and external demand growth means that investment remains weak. Further, this dynamic is not likely to change rapidly. Exports have plunged - even though since imports have slumped even further we have the ironic detail that net trade is still mildly positive for GDP. However, with interest rates at such a high level and fiscal policy being continually tightened there is little chance of a 'V' shaped recovery in Hungary, and the recession has all the hallmarks of becoming an 'L' shaped" one.

Even the agricultural sector due to the high base effect of last years bumper harvest. So basically, it's back and back in time we go at the moment.

Retail Sales In Continuous Decline

Hungarian retail sales fell for the 25th consecutive month in February as rising unemployment falling wages and a generally deepening recession sapped consumer spending. Retail sales were down an annual 3.2 percent following a 2.8 percent decline in January, according to national statistics office data. Prime Minister Gordon Bajnai, who replaced Ferenc Gyurcsany last month as differences over how to handle the recession boiled over, has indicated he plans to raise the value-added tax as the recession cuts into budget revenue. This will surely push sales down even lower, and household consumption is now expected to decline by as much as 8 percent this year, according to the most recent government estimates.

Consumers started finding themselves with less to spend following the introduction of the government austerity programme in 2006 which raised taxes and utility prices.

Unemployment On the Up and Up

Hungary's jobless rate rose to 9.7% in March, up sharply from the 8% level recorded in December. Hungary's unemployment rate has been howevering continuously in the 7%-8% range for more or les 4 years now, so the current spike (with the prospect of more to come) suggests something important has changed. Between Q4 2008 and Q1 2009, unemployment claims rose by 66,000.

Of the country’s 402,800 registered unemployed, 42.5 percent have been out of work for at least a year, now. The number of Hungarians employed averaged 3.76 million in the first quarter, compared with 3.88 million in the previous three months. It is hard to see a resurgence in the number of Hungarian's employed, even after this recession is past and forgotten, since the working age population is falling steadily, and has been for some time now.

Alongside the increase in unemployment the activity rate has declined even more rapidly. Of the 117,000 laid off during the last quarter some 40,000 chose to remain inactive rather than looking for employment elsewhere. Hungary's already languishing job market received a major blow from the global economic crisis in the form of layoffs and bankruptcies, meanwhile, companies may have been more cautious in hiring new staffers. These job market trends were only to be expected, however downsizing is on a higher scale compared with forecasts. Hungary's economy is in a state of deep recession, with predictable consequences for employment, real wages, and demand.

One consequence of the sharpnesss of the recession has been that Hungarian aggregate wages are falling much more rapidly than anticipated, and this, in turn, has put a major dent in the new government's fiscal adjustment plans. The Finance Ministry had originally anticipated an additional HUF 50 billion in tax revenue. However, the new unemployment figures suggest that the decrease in wage costs may surpass the government's most recent 2% forecast. In a worst-case scenario, the drop in aggregate earnings may be as high as 4%, with a HUF 100 billion-HUF 150 billion negative impact on the budget.

Exports Continue To Fall

Hungary posted a foreign trade surplus of EUR 492.8 million in March, the largest in the past decade, according to the Central Statistics Office (KSH). Still exports were down by nearly 20% year on year, and the improved balance was the result of imports falling even more - by over 23%.

In fact Hungary's exports came in at EUR 5,173 million in March - an 18.2% year on year decline, a considerably slower rate of decline than that registered a month ago (-29.7%). Imports came in at EUR 4,680 million , a staggering 23.4% drop, following a plunge of 32.3% in February.

The gap between export and import growth (5.2 percentage points) has not been as wide as this this wide September 2007 (5.9 percentage points). The March balance shows a record high, a surplus of EUR 492.8 million, which compares with a surplus of EUR 213.9 million in March last year. Exports in the first quarter as a whole amounted to EUR 13,843 million, a decline of 26.3% in annual terms. Imports in Q1 amounted to EUR 13,233 million, down 28.5% year on year. Hungary's Q1 foreign trade balance showed a surplus of EUR 609.3 million, another record, which compares with a surplus of EUR 282.1 million for the same period of 2008.

And Industrial Output Slumps

With exports slumping in this way it is not surprising to find that Hungary's industrial production dropped by 19.6% in March, according to working day adjusted data. Over the first quarter Hungarian industrial output declined by 22.3% year on year, but - although it rose 4.3% month on month, according to data adjusted for calender and working day changes.

And activity in Hungary's manufacturing sector continued to contract in April according to the PMI reading, although the pace of contraction is now down slightly from January's all-time low.

The headline manufacturing PMI stood at a seasonally adjusted 40.4 in April, up slightly from the 39.5 registered in March, according to the release from the Hungarian association of logistics. This was the seventh consecutive month of contraction, following the all-time low of 38.5 hit in January. The Hungarian government currently forecasts that GDP will contract by as much as 6% this year as the German economy, Hungary's chief export market, also faces a similar decline in GDP. Hungarian manufacturing output contracted even more in April than in March, to 37.1 from 37.6. The export index showed a further decline to 35.6 from 36.5 in March. The only positive development came from the new orders index which showed a marginal increase to 37.5 from a reading of 35.0 in March.

Only Inflation Rebounds

Hungary’s inflation rate unexpectedly rose in April for the first time in 11 months, after a weaker forint made imports more expensive, with prices of fuel, medicine, clothing and new cars leading the rise. The annual rate was 3.4 percent, rising from 2.9 percent in March to what is its highest level so far this year. Core inflation, which filters out food and energy prices, was 3.2 percent on the year and 0.5 percent on the month. The annual rate had returned to the central bank’s 3 percent target in February for the first time in more than two years.

The prices of consumer durables, including cars, rose 1.4 percent in a month, while fuel costs climbed 2.9 percent and medicines by 1.9 percent. The price of clothing increased 3.7 percent, the statistics office said. With Hungary’s recession damping demand, consumer prices are set to increase “only moderately,” according to the central bank. Policy makers now expect the inflation rate to average 3.7 percent this year and 2.8 percent next year. The bank raised its estimate from an earlier forecast of between 3.1 percent and 3.4 percent for 2009 and 1.5 to 1.9 percent for 2010.

One factor which will influence future inflation is the new government's decision to raise the main value-added tax rate to 25 percent from 20 percent, as of July 1 in an attempt to offset declines in state revenue and narrow the budget gap. Raising the rate of consumption tax is deeply problematic in the sort of double-bind situation which Hungary faces. Germany raised VAT by 3 percentage points on 1st January 2007, and look what happened to consumption (see chart below) in December 2006, and then subsequently. This is doubly relevant to the Hungarian case since the Hungarian economy is more than likely set on the German path of becoming an export dependent economy. Weakening domestic consumption further could well prove to be a "lethal dose".

Magyar Nemzeti Bank policy makers expect the annual inflation rate to be “near” their 3 percent goal “on the monetary policy horizon” of five to eight months, they said on May 8.

“The NBH would clearly like to cut interest rates, which at 9.5% look far to high for an economy that will contract by 5-6% this year, but this is more dependent on global financial stability and declining risk aversion than the latest CPI release." Nigel Rendell, Royal Bank of Canada

And So The NBH Keeps Rates On Hold

Hungarian monetary policy makers left the benchmark interest rate unchanged at their April meeting for a third month as concern over the forint’s decline outweighed the outlook for slowing inflation and growth. The Magyar Nemzeti Bank kept the two-week deposit rate at 9.5 percent.
Policy makers didn’t consider cutting the interest rate in March based on stability concerns (according to the minutes) and even rejected a proposal, backed by Governor Andreas Simor and his two deputies, to raise the key rate to 10.5 percent. In April the rate-setting Monetary Council considered the recession, the outlook for inflation and economic stability when setting the key rate. The annual inflation rate may be near the bank’s 3 percent target on the 18-month monetary policy horizon, according to the statement.

Much Ado About Debt

Zsuzsa Mosolygó and Lajos Deli, of the Hungarian Government Debt Management Agency recently published what they call " a first a simple model to analyze the impact of the international credit line on debt ratio trends as well as to demonstrate the importance of calibrating reasonable values for decisive macroeconomic parameters".

Read stress tests.

Below you will find the chart showing their basic assumptions, and giving the outcomes for the various scenarios. The whole idea of the process was to show that Hungarian debt to GDP will not necessarily rise in the future as some analysts had been predicting. I don't want to go into all of this in too much, but if you click on the chart and take a look at the assmptions for GDP growth (which is actually the key parameter), you will find that on both the basic and the pessimistic scenarios average growth of 3% is assumed (this is impossible to attain on my view), while the "optimistic" scenario even assumes 4% (incredible). Remember these are average growth rates and over seven years (2013 - 2020). This is like selling Spanish property pre 2007 with a splendid photo of the sun and the beach.

And this comes from two apparently serious analysts, analysts who are supposed to be committed to taking a serious stab at putting the country's longer term finances on a stable footing. All they actually acheive is offering a confirmation of the worst fears of those of us who feel that the debt dynamics in Hungary are totally unstable in the mid term, and illustrate just how out of balance most of Eastern Europe now is as we move forward.

They justify their decision in the following way:

Market analysts tend to assume in their debt models a 2% economic growth for the
Hungarian economy. The National Bank of Hungary estimates currently a 2%
potential GDP growth rate, however, it does not mean necessarily the long-term
economic growth. A few years ago the estimates were higher and it seems to be
possible that adequate reforms to encourage employment would result in a 3-4% or
even higher potential GDP growth rate.

(Please Click On Image For Better Viewing)

In fact the objective of the study was not to seriously stress test Hungarian debt dynamics, but to try to argue that those analysts arguing for unsustainable dynamics have it wrong. The end product isn't very convincing. Not surprsingly the debt to GDP ratio diminishes gradually after 2009 both in the “optimistic" and “basic" version. The authors even underline that debt development does not appear to be unsustainable under very pessimistic macroeconomic conditions, either. In the “pessimistic" scenario debt ratio peaks at about 80% in 2020 and descends slowly afterwards (which is due to the assumed 6% interest rates). Of course, "pessimistic" here means Hungarian GDP rising by 3% a year every year from 2013 to 2020. To put this in perspective, using current Hungarian government forecasts average GDP in the ten years up to 2010 is something like 1.8% per annum. And this has been a pretty good decade by Hungarian standards (see chart for long term growth).

In fact, with a declining and ageing workforce, together with decline domestic consumption (see retail sales chart above), even a 1% per annum growth rate may be optimistic. In any event we won't see 3%, and nothing produced by the Hungarian government to date substantiates the claim that longer term debt is NOT on an unsustainable path. "To sleep, perchance to dream-ay, there's the rub."

Monday, May 18, 2009

Is The Indian Economy Heading For Its Finest Hour?

"For what it’s worth, a key conclusion from the IMF’s new World Economic Outlook is that recessions caused by financial crisis typically end with export booms, with the trade balance improving,on average, by more than 3 percent of GDP. I find this a disturbing result: we’re now suffering from a global financial crisis, which means that the usual driver of recovery will only be available if we can find another planet to export to."
Paul Krugman

With results still coming in, projections show the United Progressive Alliance is likely to win about 250 seats, making it a shoo-in to form the next government and provide continuity, a stable administration and progress on key economic and corporate reforms.
Wall Street Journal, May 16 2009

Prime Minister Manmohan Singh’s electoral victory, the biggest any Indian politician has scored in two decades, may loosen political shackles that have restrained the country’s economic growth as it struggles to free half a billion people from poverty.....Political stability will make India a more attractive investment destination as Singh, 76, seeks the funds to stimulate Asia’s third largest economy.
Bloomberg, May 18 2009

Many are called, but few are chosen, as the saying goes. But could it just be that this time around, and on a one-off, never to be repeated basis, India might find itself right there in the midst of things, with a 50-50 opportunity to add its name to that select and noble band, the chosen few. After all, someone has to lead the next global charge? The majority of the developed economies are either bogged down in the substantial quantities of debt that they desperately need to pay off, or weighted down by those elderly populations who are weakening consumption growth and leading to export dependence (Germany, Japan...). And as Krugman humorously points out, someone will have to add the extra demand which will allow global trade to start to grow again, so why should India not supply a significant part of this new demand, after all we are more likely to find consumers in India than we are on Mars.

In fact, I may not be the only person around who believes this, since India's Sensitive stock index, or Sensex, surged 2,099.21 points to 14,272.63 first thing this (Monday) morning, posting a record 17 percent gain in a brief period of trading following the news of the election outcome, before the surge prompted exchanges to halt trading at 9:55 am, Mumbai time. Markets closed initially for 2 hours but the decision was then extended to include the rest of the trading day, the first time ever that this has happened to the Sensex. The stock index had previously climbed 23 percent so far this year while the Nifty Index was up by 24 percent. climbed 47 percent In fact since hitting "bottom" and closing at a three-year low on March 9, the Sensex had already risen by 47 percent while the rupee was up 4.4 percent in the same period.

The rupee also powered up again toady, and jumped the most in two decades while bonds also rose. The reason for the surge is not a feeling of deep-seated admiration for the Singh government itself, but rather a sense of optimisim that it will give India the continuity and stability it needs to grasp the challenge before it with both hands.

The rupee strengthened 3.1 percent, the most for a single day since March 1986, and closed at 47.92 per dollar at 5 p.m. in Mumbai. That took its gains this month to 4.5 percent, the best among the 10 most-active Asian currencies outside Japan. This contrasts sharply with today's performance by currencies in the more export dependent economies, with the Korean won falling 0.2 percent, Malaysia’s ringgit dropping 0.7 percent to 3.5750, and the Singapore dollar weakening by 0.2 percent. The reason for today's general fall was negative investor sentiment towards riskier assets following the Eurostat report last Friday that the EU economies contracted the most in at least 13 years in Q1.

From "Hindu Growth" To A Global Powerhouse

But why so much enthusiasm now? Certainly India's post independence growth record has been notoriously uneven, with growth rates up to the 1980s low and extremely volatile. But then, in the 1980s and 1990s things started to change, economic reform began to get off the ground, tentatively at first, and more substantially later, while Inda's demographic profile started to improve, as the country faced the prospect of a steadily growing, healthier and better educated workforce. Post 2000 growth really started to take off - and has averaged around 7 percent since then. In 2007 the Indian economy maintained an impressive 9 per cent growth rate, despite the arrival of the sub-prime crisis (although not a few were talking of overheating, and "bubbles"), only then to drop back to a 7.3 percent rate in 2008, with the IMF are currently forecasting growth of 4.5 percent in 2009.

Evidence of the recent slowdown in the Indian economy is now - like the ubiquitous IT technician - everywhere, but this, it should be stressed, is a "slowdown" and not an outright crisis of the kind we are seeing in many other countries. GDP growth slowed in Q4 2008 to 5.3 percent (from 7.6 percent in Q3), a serious development, but not an outright disaster.

Industrial output also fell year on year by about 1 percent during the first three months of 2009, which compared to the 8.7 percent rise in the first quarter of 2008 was disturbing, eespecially since this is the first time we have seen a quarterly contraction in many years. Money supply has remained rather more constant, and M3 growth to mid February 2009 was an annual 19.9 percent as compared to 21.6 percent growth last year, so the rate of increase has only eased marginally. And in the meantime the annual rate of wholesale price inflation has fallen back strongly, hitting an estimated 0.48 percent at the start of May. But then, since money supply growth hasn't slackened that much, there has evidently been a significant weakening in internal demand (alongside the obvious fall in commodity prices).

A number of fiscal stimulus packages have been put in place, and as a result the fiscal deficit from April 2008 to January 2009 was 174.3 per cent above that for the corresponding period a year earlier. The revenue deficit was up by 278 percent higher, indicating very strong pressures on the fiscal deficit and a significant departure from the The Fiscal Responsibility and Budget Management Act (FRBM). This surge in the fiscal deficit has been widely criticised, and Standard and Poor's reduced India’s rating outlook to negative from stable in February, citing the danger that “continued loose fiscal policy would result in a downgrade” in the country’s credit rating. In the meantime it affirmed India’s BBB- long-term credit rating, the lowest investment grade level.

But there are reasons for optimism. As Duvvuri Subbarao (Governor of the Reserve Bank of India) argued in a speech - ‘India, Managing the Impact of the Global Financial Crisis’ - delivered to the Conference of Indian Industries on 26 March this year, the Indian economy has been spared the worst of the blast from the present crisis for two reasons. The Indian economy is still not sufficiently "open" to take a direct hit - only 15 percent of the Indian economy is export oriented - and Indian banks and financial corporations were relatively free of contamination from "toxic" instruments.

Why Should We Expect A Ressurgence In Indian Growth?

In order to understand what may happen next, perhaps the most import thing to grasp is what it was that just happened. In some ways a quick look at look at the Reuters/Jeffries CRB commodities index (see chart below) says it all. The chart - which shows the evolution of this index from the mid 1990s to date - immediately makes a number of important details about what has been going on incredibly clear. In the first place we can see how, after long languising idly around some sort of mean, a secular rise in commodity prices starts up around 2002 and last for around four years, eventually flattening out from between 2006 to mid 2007. After this there was a further strong surge forward in the autumn of 2007 which lead to a sharp spike upwards. Basically, you could say (with the benefit of hindsight) that this period from August 2007 to July 2008 was the "overheating" period, as the growth crisis in the developed economies which followed the initial wave of "financial turbulence" in the US lead to massive inflows of funds into the BRIC and other emerging economies. This produced a sharp spike in commodity price inflation, and monetary tightening in one emerging economy after another. A desperate attempt to avoid the inevitable correction in the global economy which would follow the sub-prime "blow out" was "forcing" growth in the emerging economies at a rate they could not withstand (given global resource constraints), and the thing inevitably had to burst. Commodities peaked in July 2008, but the correction in the real economy only set in following the aftermath of the collapse of Lehman Brothers in October.

The Reuters Jeffries index hit an all-time series high of 473.518 on 2 July 2008, but was still stuck in the low 200s as we entered May 2009.

So the real point I want to make about India's current growth slowdown is that it does not have "made in Delhi" written all over it, it is not the result of any inherent problem with the Indian economy as such. It is rather the local reflection of much more general problems at the global level, whereby the Indian economy was first accelerated and then half crashed. And this is precisely why I personally think the recent (and highly controversial) US bank stress tests were so important, not because of their significance from a US banking point ofview (which is what all the fuss was about), but because of the reassurance they can give market participants that we are not going to see another financial explosion in the United States (as opposed to a protracted recession, and slow recovery). Uncle Ben is thus underwriting the recovery in emergent economies like India and Brazil by offering the reassurance that investors need that there will not be another violent bout of instability. What India and Brazil now most need is for Ben Benanke to commit to mainaining US interest rates near zero for a sustained period of time, so that people can practice "carry" with a certain degree of confidence that things won't unwind, then, I think, we are up, up and away. So, on behalf of everyone concerned, thank you Ben.

Here Come The Opportunities

India’s inflation rate stayed under one percent for a ninth consecutive week at the start of May, giving the central bank a much needed margin to keep the current record-low interest rates in place and offering the outlook of inflation free economic growth for some time to come. With so much slack in the global economy, a sudden surge in commodity prices like the one we saw in the autumn of 2008 is most unlikely, and so, as they say, while the cat is away the mice can well and truly play.

Wholesale prices rose a mere 0.48 percent year on year in the week to May 2 following a 0.70 percent increase in the previous week.

Not everyone is convinced the outlook is so benign, and Reserve Bank of India Governor Duvvuri Subbarao said only last week policy makers need to begin to think about when they will begin reversing their expansionary steps. The current RBI forecast is for inflation to climb back towards 4 percent by March 31 as the economy gradually revives. Some evidence to support Subbarao's fears can be garnered from the evolution of consumer prices paid by industrial workers, which rose 9.63 percent in February from a year earlier, after gaining 10.45 percent the previous month, according to government data. Consumer-price inflation for farm workers was 10.79 percent. India, in fact, has four consumer-price indices and as a result tends to rely on the wholesale price index as benchmark because since it is felt the consumer price indices don’t adequately capture the aggregate price. However, the disconnect between wholesale and consumer prices that we can see at this point can be more a reflection of the fall in commodity prices and the presence of excess capacity on the supply side, so the evolution of these indices needs to be carefully monitored.

The RBI has now slashed borrowing costs six times in the past seven months, with the reverse repurchase rate being cut by a quarter-point to 3.25 percent as recently as April 21.
This means the bank has now lowered the benchmark by 275 basis points since last October, while the repurchase rate has been reduced by 425 basis points over the same period to its current 4.75 percent level.

As I say governor Subbarao is rightly cautious about reducing interest rates further as Indian consumer price gains remain high, suggesting that local demand hasn’t been completely dented even as the rest of the world remains mired in a recession. Cheaper loans are helping stoke consumer spending. “The fiscal and monetary stimulus measures initiated coupled with lower commodity prices could cushion the downturn in the growth momentum” over 2009 to 2010, the central bank said recently. “Notwithstanding the contraction of global demand, growth prospects in India continue to remain favorable compared to most countries.”

And between now and September, the central bank is set to inject another 1.2 trillion rupees ($23.8 billion) into the banking system by purchasing government bonds via auctions and buying back market stabilization bonds, which were sold in the past four years to drain money from the economy. The injection is estimated to be the equivalent of a 3 percentage point reduction in the cash reserve ratio, according to the Reserve Bank.

Subbarao’s optimism is also based on forecasts for this year’s monsoon rains - which look set to be normal. If this expectation is confirmed it will help sustain the unprecedented 4.3 percent average annual farm production growth recorded since 2005, boosting incomes for the three-fifths of India’s 1.2 billion people who depend on agriculture for their livelihood while keeping price inflation modest to feed to consumption of India's urban workforce.

Sibbarao is also aware that India is much less vulnerable to the global economic slump than most of its neighbors since exports only constitute about a quarter of the economy, as compared with around a half for developing Asia as a whole. So India is less open, and while in general terms this would not be an advantage, during the current slump in world trade it is an evident plus.

Industrial Output Falls Sharply In Q1 2009

India’s industrial production fell the most in 16 years in March as the worst global recession since World War II hit demand for the country’s exports. Output at factories, utilities and mines declined 2.3 percent from a year earlier after a revised 0.7 percent drop in February. Production was dragged down in March by an 8.2 percent drop in capital-goods output (which does not bode well for short term investment), with all other categories showing improvement from February. Consumer durables production jumped 8.3 percent from a year earlier, the biggest increase in six months.

In fact the (non seasonally corrected) output index was up in March over February, and substantially up from the lows registered in the last quarter of 2008. This impression is confirmed by the purchasing managers index, which in April gave the highest reading for the Indian headline manufacturing PMI in seven months. In fact the output index registered 53.3, a level above the 50 critical one separating growth from contraction. In fact the index has now steadily risen after hitting a trough of 44.4 in December.

Just as encouraging, the new orders index rose to 54.9 from 49.5 in March. The return to growth was primarily driven by an improvement in domestic demand, according to the accompanying report. "Although the rise in new business came principally from the home market, there was also some, albeit slight, improvement in foreign demand for Indian manufactures," ABN Amro Bank said in the official release.

Also worthy of note is the fact that along with the expansion Indian manufacturers noted renewed input price inflationary pressures. A combination of increased prices for some commodities and unfavourable exchange rates led to a moderate rise in input costs during April. This is the first time that input price inflation has been recorded in India's manufacturing sector since October last year. However continuing competitive pressures meant that manufacturers did not pass on their cost pressures on to customers, and factory gate prices were cut for the sixth straight month. However, the latest drop in average prices was the weakest in the current period of falling output prices.

Employment levels across India’s manufacturing economy were little-changed during April with increased production requirements leading to recruitment on the one hand, while cost-cutting pressures produced job losses on the other.

"The April PMI gives a very clear indication that business conditions in the manufacturing sector have improved significantly after a period of sharp contraction and gradual stabilisation. The headline PMI at 53.3 has signaled expansion in activity for the first time since October 2008. Moreover, the April reading is the strongest since October 2008," according to Gaurav Kapur, Senior Economist, India, with ABN Amro. "Survey data suggests that production was ramped up during April in order to cater to a pick-up demand and to build inventories. The output index printed at 55.7 for April compared to 49.3 in March, as new incoming business expanded during the month. The domestic orientation of the improvement in demand is clearly visible from the new orders index rising well above 50, even though external demand also improved modestly. New orders index printed at 54.9 as against 49.5 in March. This is critical as it suggests that domestic demand conditions are now strong and supportive for growth in the sector,"

Car sales and the production of cement, electricity and refined petroleum are also showing signs of recovery. India’s passenger car sales increased 4.2 percent in April from a year earlier, after a 1 percent gain in March. Cement production jumped 10.1 percent in March and electricity output rose 5.9 percent from a year ago, according to government data. But exports still remain weak, with shipments declining 33 percent in March from a year earlier, the biggest fall since at least April 1995.Goods exports dropped 33 percent from a year earlier to $11.5 billion last month, the government said in New Delhi today. That was the biggest fall since at least April 1995. Exports slid 21.7 percent in February.

Exports Fall, But Without Heavy "Export Dependency" Exposure

India’s exports, which account for about 15 percent of the economy, have been falling back recently, although they were still up by 3.4 percent (to $168.7 billion) in the fiscal year ended March 31. They did however fall well short of an initial $200 billion target set by the government before the September collapse of Lehman Brothers accelerated the world financial and economic slump. The government now expect exports to total $170 billion in the year that started April 1. The decline in exports is likely to continue until at least September, according to India’s Trade Secretary Gopal K. Pillai, while falling overseas sales may cost India about 10 million jobs, according to estimates from the Federation of Indian Export Organisations.

Imports were also down in March - by an annual 34 percent - and as a result the trade deficit narrowed to $4.04 billion from $6.3 billion in March 2008. Oil imports plunged 58 percent to $3.8 billion, while non-oil imports dropped 19 percent to $11.75 billion.

However, Subbarao argues, the Indian economy has globalized rapidly during the past few years. In terms of openness to international trade the ratio of exports plus imports to GDP increased from by more than 50 per cent in the 10 years from 1997–98 to 2007–08 (from 21.2 per cent of GDP to 34.7 per cent of GDP). Furthermore, the growth of financial integration has been even more rapid. During the same 10 year period (1997–98 to 2007–08) the ratio of total external transactions (gross current account flows plus gross capital account flows to GDP) increased by more than 100 per cent from 46.8 per cent in 1997–98 to 117.4 per cent in 2007–08. Furthermore, corporate borrowing from external sources has also increased significantly. In 2007–08, for example, India received capital inflows to the extent of 9 per cent of GDP as against a current account deficit of 1.5 per cent of GDP.

Twin Deficits?

India has been facing the so-called twin deficit problem for some time now, and the poor fiscal record, together with the continuing high deficit is the main reason why international credit rating agencies have brought the country’s debt close to junk status. The fiscal problem is not an easy one - apart from running a general government fiscal deficit of a estimated 9.9 percent of GDP, the debt to GDP ratio is stubbornly stuck round the 80% level - far, far too high.

Meanwhile, capital flows have continued to be vibrant despite the huge withdrawal of money from the stock market by foreign financial institutions, or FIIs. As a result, while India's foreign exchange reserves fell initially during the crisis, they have since stabilised, and are even now begining to show signs of increasing again (see chart below). At the start of this week India's Securities and Exchange Board of India reported that foreigners bought a net $828 million of local equities on May 13, the most since February 2008. Indeed they report that overseas funds have already bought a net $1.8 billion in Indian equities so far this month, well below the heady levels of 2007, but still a significant turnaround.

Equally interesting is the change in the composition of the capital flows. FIIs withdrew an estimated $15.02 billion in 2008-09, according to Reserve Bank of India data. The scale and velocity of the withdrawal in the second half of last year certainly put significant pressure on India's money and foreign exchange markets - and short-term interest rates surged over 20% while the rupee tumbled to an all-time low of 52 against the dollar. But other types of capital inflows remained relatively strong, especially foreign direct investment, or FDI. Overseas Indians, too, sent a lot more money back home, due to the uncertainties created by the turbulence in the the developed economies and the higher interest rates on offer in India.

Taken together, the measures put in place since mid-September 2008 have ensured that the Indian financial markets continue to function in an orderly manner. The cumulative amount of primary liquidity potentially available to the financial system through these measures is about Rs.390,000 crore (78 billion dollars) or 7 per cent of GDP. This sizeable easing has ensured a comfortable liquidity position starting mid-November 2008 as evidenced by a number of indicators such as the weighted average call money rate, the overnight money market rate and the yield on the 10-year benchmark government security. Commercial banks have responded to policy rate cuts by the Reserve Bank of India by reducing their benchmark prime lending rates. Bank credit has expanded too, but slower than last year. The RBI’s rough calculations show that, on balance, the overall flow of resources to the commercial sector is less than what it was last year indicating that even though bank credit has expanded, it has not fully offset the decline in non-bank flow of resources to the commercial sector.

Of course, the present level of fiscal deficit is easy enough to justify, given the need to put a platform under the economy, and a number of stimulus packages have been announced by the Indian Government in response to the global financial crisis.

Just one such measure - the decision of India's Sixth Pay Commission (which was not a stimulus measure as such, but rather the outcome of the routine policy process, and possibly highly political in view of the impending elections) was widely criticised, although the implementation in the short term may in fact have been timely.

The Commission recommended across the board increases in salary for central government employees, to be followed in due course by comparable salary increases for state government employees. The payment was to be made in two installments, 40 percent (an estimated Rs. 1.57 trillion or roughly $31.4 billion) during 2008–09, with the remaining 60 percent coming due in 2009–10. The decision is, I say, deeply controversial, given the size of the deficit and accumulated government debt, but under the circumstances may well have served to place some sort of platform under domestic demand during times of global financial crisis.

The stimulus packages per se have also come in two installments, The first one, announced in December 2008, was largely fiscal in its intent, and included additional expenditure of Rs.3 trillion ($60 billion) over four months, a cut of 4 percent in value-added tax, as well as a 2 percent export credit for labour intensive sectors and other export incentive schemes.

The second stimulus package - announced in January 2009 - was, in contrast, mainly montary and directed towards credit easing. Among the more important measures an SPV was created to provide liquidity support for investment grade paper to specific Non Banking Finance Companies (NBFCs). The scale of liquidity potentially available was Rs.25,000 crores/$50 billion. Public Sector Banks were to provide a line of credit to NBFCs specifically for purchase of commercial vehicles. Credit targets of Public Sector Banks were revised upward to reflect the needs of the economy. Further the guarantee cover provided under the Credit Guarantee Scheme for loans to micro and small enterprises was increased from Rs 5 million to Rs 10 million with a guarantee cover of 50 per cent. In order to enhance flow of credit to micro enterprises, the government also decided to increase the guarantee cover available under the Credit Guarantee Fund Trust to 85 per cent for credit facilities of up to Rs 0.5 million. This measure should, in principle, benefit around 84 per cent of the total accounts accorded guarantee cover.

The India Infrastructure Finance Company (IIFCL) was also authorized to raise Rs 10,000 crores ($20 billion) through tax free bonds by 31 March 2009 for refinancing bank lending of longer maturity to eligible infrastructure bid-based PPP projects. This would enable the funding of mainly highway and port projects to the value of about Rs 25,000crore ($50 billion). In addition, in order to provide funding for additional projects worth about Rs 75,000 crore ($150 billion), the IIFCL is now able to access an additional Rs 30,000 crores ($60 billion) via tax free bonds once the current year's allocation of funds has been used up.

This surge in the fiscal deficit has been widely criticised, and Standard and Poor's reduced India’s rating outlook to negative from stable in February, citing the possibility that “continued loose fiscal policy would result in a downgrade” in the country’s credit rating. In the meantime it affirmed India’s BBB- long-term credit rating, the lowest investment grade level. S&P estimated that India’s national budget deficit, including off-budget items such as oil and fertilizer bonds and state government deficits, may increase to 11.4 percent in the year ending March 31 from 5.7 percent in the previous year.

Only last week Fitch Ratings also reiterated that India needs to cut its budget deficit to avoid having its credit rating lowered. “India faces considerable challenges in balancing the need for short-term stimulus measures to counter the economic downturn and the necessity of re-establishing a sustainable medium-term path for the country’s public finances,” according to the agency statement.

Fitch, which gives India a BBB- rating, its lowest investment grade, is worried that the new government may step up spending to soften the blow from slowing economic growth. If they do the ratings agency fears this will widen the general budget deficit to more than 10 percent of gross domestic product for the second year in a row in 2009-10.

And these ratings matter, since they influence investor decisions as to whether or not to hold rupee denominated assets. It should be noted however, that the ratings agencies generally have responded well to the latest election result. Both S&P and Moody’s Investors Service, were both emphasising yesterday just how the outcome gives India's government a chance to improve its fiscal situation.

The poll result gives the government more “political space” to sell stakes in state-run companies and improve revenue, according to Moody’s senior analyst Aninda Mitra, while S&P’s director of sovereign ratings Takahira Ogawa commented that the result means “there is a possibility for the government to implement various measures to reform for further expansion of the economy and for the fiscal consolidation.”

Current Account Blues?

As suggested throughout this post, the tailwinds behind the Indian economy are now incredibly favourable. A new government has just been elected which should provide stability to the country, and continuity in the realm of economic policy. The changing age structure of India’s population means that the proportion of the Indian population in the working age group (15–64 age bracket) is set to rise from 60.9 per cent in 2000 , to one which will surpass that if a developed economy like Japan by 2012, and continue to climb steadily to 66 per cent by 2030. But it isn't only quantity which is important here. Quality also matters. The nutritional status of India's population is improving rapidly, with calorie and other macro and micro nutrient deficiency on the decline. According to the 2001 Census, the literacy rate of India's population climbed from 51.54 percent in 1991 to 65.38 per cent in 2001. India will thus, in the years to come, find itself with a younger, healthier, better educated and thus more productive workforce than ever before.

At the same time, the massive slack which exists in the global economy means that Indian now has a more-or-less unique opportunity to accelerate the development process at non-inflationary growth rates well above those which would have been envisaged only two or three years ago. At the same time, as the age structure has shifted, and the weight of child dependence has reduced, India's savings rate has risen steadily from 23.4 per cent of GDP in 2000–01 to 35.4 per cent in 2007–08. During the same period investment rose from 24 per cent of GDP to 36.3 per cent of GDP, suggesting the need for a slight current account deficit to cover the gap between savings and investment.

And to return to where we started, on where the demand is going to come from to support the current global recovery. The IMF currently forecast a 2.5% of GDP current account deficit for Indian. Given the extent of investment that is needed in capital goods, technology and infrastructure this is a small, even benign, number, and at the end of the day will mean that Indian is once more playing its part in the community of nations, by adding a little extra net demand to the global pot.