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.  

Energy – elixir of the economy

My column for Wealth Insight - Feb edition:

Core inflation is down state the headlines. Manufacturers don’t have pricing power parrot the economists. There is one sector that beats this trend – the energy sector.

A few days ago, the government allowed oil marketing companies (OMC’s) to increase the price of diesel. Stock prices of OMC’s as well as upstream exploration companies (which share the marketing losses with the OMC’s) have rallied smartly.

Over the next three months, 23 states will increase the price of electricity –10% to 35%. It would appear that the energy sector provides adequate opportunity for investment. Despite this, Anil Sardana, Managing Director of Tata Power is quoted as saying “At this stage, we are not looking for any tangible business opportunities in India. I don’t see anything moving on the fuel side (or) project side.” What gives?

 Oil – slippery slope

The past two decades have seen successive governments follow a “one step forward, two step back” approach to fuel (oil) pricing. In the 90’s, the government operated an “oil pool” – whose only purpose was to allow the government to keep its liabilities “off balance sheet” while it tried to control the final consumer price of oil on the one hand, and simultaneously increase tax on it on the other. The resultant gap was parked in the “oil pool”. When the pool was dismantled, there was a reasonable expectation that market prices would rise. For some time it did. However, as global crude prices started to rise, and consumer pressure build up, government again intervened to stop OMC’s from increasing prices – the alternative would have been to reduce taxes on this highly-taxed commodity. This resulted in the OMC’s reporting losses and the government having to bail them out through use of “oil bonds” and other mechanisms.

In this context, the recent decision to allow prices to rise has been welcomed by economists. The assumption is that there is a “subsidy” that is being removed. With higher prices, government deficit would fall, reducing its need to raise additional debt. This in turn would allow interest rates to soften, and provide a strong impetus to economic growth.

Experience however does not suggest that such a simplistic situation is likely to play out. Even if the government is willing to face public ire by keeping the price of diesel going up month on month, its own borrowing is unlikely to fall – the food security bill likely to be tabled in Parliament soon, will take care of any reduction. The motive of deregulation of the sensitive oil sector in a pre-election year needs to be examined carefully.

As part of its deficit reduction plan, the government needs to divest stake in public owned companies. Among others, OIL is one such on the divestment list this time. The finance minister is wooing investors. Free pricing of petro products is likely to go down well with potential investors. The timing of the oil price hike suggests that it is not driven only by administrative “reform”. The question is – will the government stay the course and allow retail price of petro products to move in tandem with global crude prices.

Investors will recall that just prior to the previous year budget, the government had divested a significant chunk of ONGC – mostly to LIC. Within days of this divestment, the budget imposed an additional tax on ONGC, which reduced its profitability – not something the new investor would have anticipated. Aspiring participants in petro company divestment programs need to keep in mind the political sensitivity of the sector especially in the context of increased user charges in many other sectors – that too coming on the back of sustained consumer inflation. Will the government remain “unpopular” or will it re-impose a cap on price rise closer to election?

Power sector – elusive coal

Fuel linkage remains the bane of the power sector. 57% of overall installed capacity is coal based. Coal India (CIL) is almost a monopoly supplier in the country – and as with most government run monopolies – is extremely inefficient. Despite having over $10bn in cash reserves, coal India’s automation levels are abysmal.

CIL has among the lowest productivity per head among its peers around the globe. CIL uses private contractors to extract coal from its mines – at a productivity which is almost 4 times its own. International benchmarks would be perhaps 10x as much. If CIL were to use its ample cash reserves to increase its production from its mines that are currently operating, shortage of coal in India would all but disappear. The clamour for easier environmental norms is redundant – what is needed is better productivity and deeper drilling. 

In the current context however, availability of coal remains a challenge. In a report dated march 2012, Credit Suisse had pointed out that despite increased allocation to power, the “shortage” of coal at 80% of capacity would be “eliminated” only in 2017. 

Chart1 : Coal Supply to power sector increased                                     Chart 2 : supply available to 60GW capacity addition

 

This means that only 80% of the coal needed by these power plants would be made available from Coal India. It also means that 49GW of delayed projects of XI and earlier plans would not receive allocation from CIL till 2017.

The generating capacity addition of ~55GW in the XI plan (2007-2012) was the highest in any plan period. Capacity currently stands at around 207GW. ICRA estimates that 85GW of thermal capacity is under construction. Of this, 54GW is likely to come on stream in the XII plan period (2012-2017) in the private sector.  Domestic coal is likely to be available for only ~60% of the requirements of the power producers who already have fuel supply agreements (FSA). Overall dependence on coal imports is estimated to go up from 12% in FY2012, to almost 25% by FY2017 – increasing the risk in fuel supply, and therefore project risk for producers.

Gas based power plants have suffered even more, with those in South India operating at a plant load factor of less that 40% as gas availability has declined (48% all India average). With gas prices likely to go up in the next year, power prices will need to adjust for fuel costs.

All this implies that over 40GW of private sector power producers are vulnerable from a credit perspective.

In this scenario, it is not difficult to appreciate the concerns of the power producers. Until the policy makers work out a solution whereby producers (and their lenders) face reasonable certainty of projects being viable and consumers are not constantly faced with rising prices, the energy sector will remain stressed. Without energy, India’s growth objectives will remain a pipedream. The government has to work towards greater efficiency and focus on productivity to increase the availability of energy rather than to focus on increasing project investment without ensuring either the fuel or the off-take. Not a glamorous proposition – just plain old hard work.