Policymakers think global liquidity is crucial for markets. They're wrong

My column in the edit page of Economic Times . The unedited version is below.

Quantitative Easing(QE) – Markets saviour or economic bogey?

QE defined

Quantitative easing (QE) is an unorthodox way of increasing money supply in an economy. It involves the central bank increasing the size of its balance sheet and using the money to buy up assets. This provides banks more money to lend, and reduces interest rates – allowing fresh growth-inducing investments.

In the recent past three major central banks – the US Fed, the European Central Bank, and the Bank of Japan have used it to attempt to revive their domestic economy. Some economists suggest that the mild upticks we see in these economies are a result of this strategy working. Others worry that the consequences of large scale liquidity creation increases asset prices and causes inflation – especially in emerging economies.

QE effects are difficult to find

What has been the Indian experience? Ostensibly, yield seeking foreign investors should arrive in droves to arbitrage the growth (and returns) that may be achieved in India when their home country offers zero interest rates. This does not seem to have happened in the equity markets. A glance at the chart of nifty above would suggest that while QE1 seemed to succeed in raising the market, the subsequent actions of the US Fed have not. In rupee terms, the Nifty is up a measly 4% per annum for the past 3 years, while in dollar terms, the returns are a negative 2% compounded. Despite the much touted “liquidity” driver for Indian markets, atleast the equity market does not seem excited.

Liquidity infusion is supposed to increase asset prices, cause inflation, and lead to currency appreciation in the country which is the recipient of inflows. In the case of India, stock prices are up approximately 8% per annum since June 2007, real estate prices increased on average 10% per annum, and inflation (CPI) has been in the same ball-park, while currency has depreciated! Real returns from almost all asset classes seem zero or negative.

During the same time however, Gold prices have gone up approximately 21% compounded. Unlike other assets, India is perhaps a price maker rather than price taker when it comes to gold. The explanation that investors in India have chosen to use gold as a hedge against currency depreciation appears to hold water. 

Economic policy, not foreign flows, to blame for inflation

Can we blame inflation on foreign inflows? Over the past few years, M3 – a measure of money supply has grown approximately 16% per year. This fell to 14.2% in Q1 FY13, and post QE3, is now at 12.6%. Foreign inflows do not seem to have raised money supply in India.

The economic survey has identified that there are over Rs7.5 lakh crores worth of projects stuck in India due to policy issues – mining, environment, land acquisition being major problems. Inflation has mostly been caused by policy inaction leading to supply constraints and some policy action (increase of administered prices – energy and food in particular).

The Indian economy needs serious investment in infrastructure. Long term infrastructure projects are best financed by long term capital at low interest rates. The global environment offered India just such an opportunity. This was India’s best chance to increase productive capacity of the economy and allow growth without inflation. Lack of focus on “enabling” policy prevented investment in core sectors. In a world where increasing inflation is the target of most central banks, home-made inflation seems to be our own doing.

A world without QE

What could happen if liquidity were to tighten and if central banks were to reverse easy money policy? Well, if the above is true – not a whole lot! Interest rates would rise in the rest of the world as would global inflationary expectations. Since most currencies are engaged in competitive devaluation, the relative effect of currency movements would be neutralised.

Real interest rates in India may actually increase – leading to higher savings, lower dependence on foreign inflows, and better capital allocation.

Money is not a commodity that remains constant. When dealing with QE induced money flows, the question “where will the money go” is nonsensical. The money can remain on the balance sheets of banks (as happened in the initial stages of QE1 and QE2). It can also be lost when asset prices fall – like when the real estate bubble in the US burst. Investment activity should be and largely is, based on expectations of future returns. If QE3 works, it is entirely possible that developed markets will provide greater opportunities to investors than emerging markets. A case in point is the new high that the US equity markets have reached – while emerging markets like India remain below their all time highs.  Trying to guess the timing or direction of money flows is a fruitless activity.

India’s economic managers would do well to look at measures that would remove constraints in the real economy rather than focusing on financial markets. Financial markets are meant to serve as the barometer of investment outlook – fiddling with the barometer does not change the underlying reality of a poor investment climate.

BIG Pharma and costly medicines

Zerohedge carried an article on medicines in Greek and the role of BIG Pharma - reported here. The first paragraph is reproduced below:
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Greece is facing a serious shortage of medicines amid claims that pharmaceutical multinationals have halted shipments to the country because of the economic crisis and, as The Guardian reports, concerns that the drugs will be exported by middlemen because prices are higher in other European countries. Rubbing further salt into the Greek (un-medicated) wound, the Red Cross slashed its supply of donor blood to Greece because it had not paid its bills on time. Pharmacies in Greece describe chaotic scenes as clients desperately search from shop to shop for much-needed drugs. Greece's Pharmaceutical Association said "around 300 drugs are in very short supply," adding that "It's a disgrace. The companies are ensuring that they come in dribs and drabs to avoid prosecution. Everyone is really frightened." The fear for the multinationals remains that wholesalers can legally sell to other nations at higher prices and a "combination of Greece's low medicine prices and unpaid debt by the state." Lines form early and 'get very aggressive' one pharmacy exclaimed, "We have reached a tragic point."
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Recently, the "Intellectual Property Appellate Board (IPAB)" in India upheld the grant of compulsory license of a Bayer drug to Natco. Some more licenses are in the pipeline. However, what comes as a surprise is the attempt by the government to set up another committee for pricing drugs - which may effectively put a stop to this licensing. Is this a case of success of foreign lobbying. Already, price of drugs in India have risen steeply. It would indeed be unfortunate if another scam were brewing in as essential commodity as medicine.

Figures seem credible but what about the emphasis?

My budget comment in DNA - the edited version. The unedited view is below.

The budget, as an exercise in accounting credibility, seems better than many in the recent few years. If we were to accept for a moment, the assumption that GDP growth for FY14 will exceed 6% (as forecast by the economic survey), a 15% increase in excise collection, or a 17% increase in corporate tax made in the budget does not appear to be very challenging. Some figures seem optimistic – a 35% increase in service tax, high growth in divestment and dividend income and high telecom license revenues. However, this is nitpicking. Largely, the budget seems to have a reasonably consistent set of assumptions – so where is the nub?

The issue seems to revolve around the question of growth. While it may be credibly argued that the budget is not expected to resolve all policy problems, one usually looks at the budget more from the point of view of the stated goal of the fiscal policy and not just from the prism of numbers. This is where budget fails to provide an inkling of government’s plans to increase growth. Why will growth rate go up – other than because it will?

If resumption of high growth is a major concern and the private sector is not investing, would it not be logical to increase government spend on capex? Instead, we see government reducing capital expenditure in the current year by 22% lower than the budgeted amount. Why the excessive focus on fiscal deficit in a cyclically weak year? The argument that interest rates will go up have been proven to be untrue – we continue to have negative or near zero real interest rates. And, inflation remains high because of government policy of passing on price of its inefficiency to the public.

The economic survey itself is confused on its understanding on interest rates. At one point, the survey states that household savings in financial assets have fallen since inflation reduces attractiveness of financial instruments and suggests that inflation linked bonds should be introduced – a suggestion which the finance minister too takes up. This would imply that interest rates should go UP.

However, the survey promptly then blames high interest rate for lower investment by the private sector. The survey itself admits that private investment is down because of Rs7500bn worth of stalled projects. “Analysis of 20 individual projects (making up 70% of the total cost of the shelved projects) suggests difficulties in land acquisition, coal linkages, and mining bans as major causes.” None of this suggests a problem with interest rates. Presumably, since this seems an implied criticism of government’s inability to frame workable policies, the problem must be laid at that door of monetary policy.

To borrow a term from Paul Krugman, the “confidence fairies” have made their way to India as well. Somehow, unless the fiscal deficit is contained, interest rates will go up – despite evidence to the contrary. So the path to growth remains shrouded in mystery.

Overall corporate earnings growth is likely to be downgraded by a couple of percentage points to accommodate the increase in surcharge and other changes in tax rates proposed. This will likely reduce sensex earnings estimates to below 1400 for FY14. With little likelihood for a rapid reduction in nominal interest or inflation in the near term, markets will continue to be in the grip of global shifts in risk perception. Unless we have more and better policy action following, the outlook for equity in the current year continues to remain subdued.