Exiting the stimulus :
(Core Idea) Yes to Gradual & systematic withdrawal But Timing remains a Crucial Challenge !
(Debates) : Inflation v/s growth & Stimulus V/s Deficits
While the economists all around were still grappling with the idea of success of Keynesian economics bearing fruits , to their surprise and to that of IMF ,the world economy recovered stronger than expected ( http://economictimes.indiatimes.com/Global-recovery-stronger-than-expected-IMF/articleshow/5448195.cms). Although , the debate still remains whether quantitative recovery can be explained by the fiscal ( and monetary )stimulus.No doubt , I believe the size and quantity did work wonders ( Germany & France as we saw were first to get out of troubled waters sooner , china & india (ofcourse along with other factors of Chindia potentials) registered very encouraging growth rates , at the same time UK still grapples with record 6th straight quarter of recession.
| Nations | Stimulus | % of GDP |
| China | US $ 586 billion | above 12.9% |
| India | Please find out and fill | Please find out and fill |
| US | (US$ 787 billion) | |
| Germany | US $ 110 billion | 2.8 % |
| Italy | | 0.3% |
| UK | | 1.3% |
| Total world | US $ 2 trillion | 1.4% of the world’s GDP ( still lesser than 2 % recommendation by IMF) |
Exit Debate
1) Short term impact of fiscal tightening on growth in a “recovering” economy is not well understood.
The response to crisis was simply by transferring the debt-burden of “ balance sheets “ of companies to the governments balance sheets- leading the government to tread on dangerous territories. ( deficit in UK and US is of order 10%).The governments managed this by bonds (investers in crisis were ready to seek safer havens ) and QE (quantitave easing ) by central banks.But can this be sustained further with yields( 10 yr T-bonds) rising by about .5% across globe.?Governments main business is to run country and not banks .Even governments can fail ( Abu Dhabhi rescue of Dubai , Ireland etc)
Investors across globe want government to reduce deficits by way of spending cuts .But government and policy makers are vary of it because they don’t really understand the SHORT TERM IMPACT OF FISCAL TIGHTENNING.But then the ugly balance sheets of governments puts them in dicey situation.
2) Timing will be KEY for the Exit strategy
Although one understands that there is need to fix balance sheets (fiscal consolidation) and address the inflationary concerns by having a clearly formulated, defined and coordinated exit strategy in place.
There are risks associated with timing on either sides
(A) Early exit may lead to Dampening the Growth of recovering economies , which are still fragile and even more susceptible to shocks given the sudden recovery.
(B) Prolonged exit on other hand will pump the inflation on account of overdose of liquidity and (may cause) asset bubbles .Markets have been rising unabated, valuations are very expensive , the underlying GDP growth will find hard to match such expectations. ( more so on account of unsustainable government stimulus ) and such a situation is recepie for disaster , Something has to give amidst ( Refer to Economist Issue Page 9 , Jan 9 , 2010)
· High asset prices
· Low interest rates
· Crtical fiscal deficits
So While we can agree now ( although not in exact quantitative terms ) that Fiscal Stimuls ---led to recovery and avoided Great Depressions ( turning it into Great Recession rather) , the policy makers can still jeopardize the entire recovery because to be true nobody really understands the causal link in this process.however , if so , any decision taken should take into account the following points
· Monetary and fiscal policy changes will have to be coordinated
· main aim of any intervention should be to support growth and maintain price stability.
With regards to above two points , the easiest and safest way out appears to be could be raising the interest rate on banks’ reserves at the central bank as it will allow the central banks to mop up the excessive liquidity in the banking system by making sure the money is deposited back at the central bank and in so doing prevent excess credit creation and also inflation eventually. ( refer : Chinese rate hikes in response to so called "structural bubbles threaten to emerge": Liu Mingkang, the top banking regulator, wrote in an opinion piece in Bloomberg News this week that "structural bubbles threaten to emerge" in the world's fastest-growing economy) .
This comes at a time when few scholars compared this “Commodity boom “ in china to Japanese asset bubble.( also housing market boom in china is questionable). But , the very idea of comparing Chinese growth to Japanese in 80;s is screwed ( refer article by Thomas Friedman “ is china the next japan”). Let us , however shift focus back to home , where the Sugar is no more sweet for the Government .
India’s Exit Strategy
Having agreed that in short term interest rate hike is better strategy , and phased exit of fiscal stimulus is key. ( However , prolonged stimulus should be given to the export sector esp in India).
Again the questions are
1) Growth v.s . Inflation 2) Asset Bubbles .Any real signs in India ? 3) Fiscal consolidation ( fiscal deficit v.s stimulus)
1) Growth v/s Inflation
A rate hike will set back the recovery process, but if RBI does raise rates, it will be to prevent the rise in food prices from spilling over to other sectors and to dampen inflationary expectations. FM , RBI chief all have agreed to prolong the stimulus , CII crawled on knees of government to continue the stimulus. SBI chief believes that rate hikes are out of question and even if done banks have sufficient liquidity ( and the competition amongst bank will also help ) to keep interest rates low .Jan was expected to show crr hike but it did not happen, Stocks markets are still cautious and are showing consolidation on current levels, till the RBI review scheduled at end of this month.
1( a) Growth
Turning back to macroeconomics of India which registered 7.5+ % growth last Quarter and some say this quarter will show 9 % growth., Recent data shows that exports have started growing, albeit over a depressed base. All this has improved the growth prospects for the current fiscal, leading all the key forecasters to scale up their India growth estimates for 2009-10.
1( b) Inflation
But, what about the inflationary pressures ? In its October policy, RBI had raised the fiscal yearend inflation target to 6.5 per cent. Given the speed with which inflation is rising, it is quite likely that this target will be breached much before that. The weak base of last year is further pushing inflation up.
Under normal situation , a simultaneous rise in growth and inflation would have triggered a rate hike. The nature of inflation, however, makes the monetary policy decision quite complicated.
We need to understand the INFLATION components. The pressure on inflation is largely due to a supply shock from agriculture and not due to demand factors. The deficiency in this year's monsoon has led to a sharp 18 per cent drop in the kharif food grain output. This could have been tackled by Government stocks disimbursement.
For the month of November 2009, food inflation stood at 17 percent, fuel inflation was negative and manufactured product inflation was 4.0 per cent. Similar data is for December 2009( The reader can check for latest data which I could not google out J )
It is well understood that the spike in food prices cannot be arrested by raising interest rates. ( Atleast we are sure of something J )
Since , The factors here viz,
· structural ( low productivity , poor monsoon , low supply )
· policy-induced factors ( late distribution of govt stocks, latency by govt)
Such factors , Can’t be tamed by Monetary Policy .
But ,
Food Price Inflation has uncanny ability to give rise to GENERALISED INFLATION. (Food price inflation has the Destructive ability to percolate across boards and cause Cumulative increases in other components of Inflation measure baskets. (Hence, there is a counterview too )
The idea I biliv is of EXPLICIT MONETARY TIGHTENNING ( read interest rate hikes) IN Response to Occurrence of Any such Generalized Inflation as discussed above rather than implicit monetary tightening in response to current food price inflation.
2) Fiscal Consolidation
It is pretty clear that bank credit disbursals have just started picking up from a 12-year low, though the banking system still has surplus liquidity as indicated by the amount of funds being parked with RBI in its daily reverse repo auctions.
A Concern is that interest rates are already high in India due to the impact of a sudden increase in government borrowing following the onset of the global financial crisis.
( 10-year government securities has hardened from a low of below 5.0 per cent in January 2009 to about 7.6 per cent currently. This has, to some extent, off-set the impact of monetary easing, so actual lending rates have not declined to the same extent as policy rates. )
Monetary tightening would only result in a further increase in bond yields which would increase the government's interest costs and pose a challenge to fiscal consolidation.
And ofcourse , above views are naturally ALINGED TO CII views too .( Ref: Interest rate hikes and crowding out of private investments. An increase in RBI's policy rate at this stage would only encourage banks to stay away from commercial lending. .)
3) Assets Bubbles ?? ( let us limit our discussion to India Only )
Let me quote RBI chief ( Jan 17th 2010) where he assures there was no threat of a capital surge or an asset bubble building up at present.
o ” capital inflows are roughly in line with our current account deficit. We cannot call it a capital surge like that what happened in 2006-08” he says.
o ” Every asset price build-up need not necessarily result in a bubble. We are keeping a vigil”.He adds .
But , can this view be trusted ? (
At around 16, the expected price/earnings multiple for 2010 for India is higher than that of Korea, China and equal to Taiwan.
Let us look at the CAPITAL FLOWS to understand this
(A) FII INFLOWS
FII inflows have not been sufficient and can even lessen on account of
1) interest rate hikes (Higher inflation will lead to gradual increase in interest rates if signs indicate demand led inflationary pressures. Currently it’s largely a lack-of-supply oriented inflation, which is CANT BE CORRECTED IN SHORT TERM as we have already discussed above.)
2) Rise of value of US dollar vis a vis Rupee
3) Fiscal deficit. The disinvestment is not capable of controlling it.
While FII flows have been heavy in the latter part of 2009, they haven’t yet led to inflating asset prices to a level where there is serious concern.Is this pace of flows likely to continue? If it does continue into 2010, leading to sectors or stock prices running ahead of their 2011 earnings (imminently possible), there could be a potential bubble forming.
B. FDI Contribution : Too Tiny , Growth expected and appreciated.
There’s probably enough and more appetite for FDI flows further into India. They will not create an asset bubble.
· given the consistently growing size of the economy
· hunger for increasingly larger project implementation in various sectors.
· longer term outlook of FDI flows
· FDI flows into India are not a concern. In fact the country could do with more !!!!
So , experts views is that as of now there are no signs Bubbles Formation .
However, When similar experts talk about the speculative commodities market , there is no denying to the presence of Asset bubbles all across Asia ( esp China and India ) .A calculated risk has to be taken therefore to curb these bubbles.Especially in the year where we are expecting the divorce of dollar-oil negative correlation ( Goldmann Sachs). Commodities like oil, gold, metals, we might just have a potential bubble forming there.
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