Dollar, Fed and Global inflation

The recent decision of the US Federal Reserve (Fed) to cut their interest rates by 50 basis points in response to the sub prime crisis may lead to new problems. Global inflation which has been unusually benign for the last decade or so because of the surge in globalization seems all set to make a dramatic come back. Oil is past 80$ to a barrel and gold has climbed to 28 year highs threatening to go past 800$ an ounce. Food inflation is already running between 5 and 15% in most countries with a combination of environmental disasters and diversion of crops to bio-fuels adding to shortages. Whether it is wheat, corn or some other cereals globally or shortages of pork in China, or tortillas in Mexico, food inflation is going to be both politically and economically a major issue in the coming months. In such a scenario, the Fed has cut interest rates and it sure had its reasons, what with the R word being bandied out by every other economist. But this cut, which effectively will add a new global flood of liquidity will probably create another asset bubble to add to the global stock and housing bubbles. This new bubble according to economists might be in emerging markets. Most of these markets are already at or close to their life time highs. How long this emerging market party will last will again ironically depend on inflation. If the dollar continues to fall and global inflation makes a comeback piggyriding on oil, commodities and food, the Fed will have to go back to increasing rates and Alan Greenspan's prophecy of 10% interest rates may not be that far. This will almost surely stall the global economy if not bring out a full blown recession. Asset markets whether property or stocks worldover will take a massive knock. Globalization has made sure that economic booms and crises will now be global. The assets to own in the event of such a crisis will surely be Gold and ironically the dollar. Once the Fed starts raising rates, the dollar will start to make a massive comeback both against emerging market currencies as well as the euro and the yen. If all this is beginning to sound scary, it actually is. This has to be one of the worst times to predict where the asset markets are headed. All we can hope is that inflation continues to somehow remain benign and the Fed can pull the US economy and the world out of this current mess.

The Farmer, The Housewife and the political tap dance

When I first thought about blogging, the one topic that I swore myself to never write about was politics. But the link between politics and economics is such that completely ignoring it is quite difficult. So as a compromise, I decided to write at least about the absurd effect economics plays on politics and vice versa. This brings me to the title of this blog, 'The Farmer, the Housewife and the political tap dance'.

Elections in India have often been lost on issues such as prices of agricultural commodities. In a funny manner they have been lost, both for high as well as low prices. In the high price cases, its usually the urban voters spurred on by the anger of housewives and their household budgets and in the low cases, its the farmer's anger and the rural vote that cause election losses. This results in the unique tap dance that the Indian government performs, trying very hard to keep both these constituents happy.

The wheat saga that is being played out this season is a reflection of this dilemma that the government faces. They first increased the MSP (minimum support price) to Rs 850 a quintal including a Rs 50 bonus thats supposed to help farmers, then discreetly ordered private companies to desist from buying wheat from farmers at a higher than MSP price fearing that it will be crowded out of the market and not have enough stock of grain for its Public distribution system, then followed up these absurdities by further banning exports and allowing duty free imports. All these activities with the pious intentions of somehow helping both the farmers as well as consumers. The easiest way would seem to be to eliminate the middlemen, where the farmers receive nearly the same amount as consumers pay. This could happen with the entry of big time retailers like Reliance, ITC, Walmart etc who could buy large quantities of agro-commodities and then sell it to consumers. Competition between them could keep their margins low benefiting both the farmers as well as consumers.

But like everything else in India even this is not as simple. There's a whole third constituency whose livelihoods depend exactly on this margin between farmers and consumers. This is the vocal section of traders, small shopkeeper's, wholesale businessmen etc who do not want the entry of the above mentioned largescale retailers, since they can offer higher prices to farmers and eliminate them from the market. That results in the whole "prevent foreign retailers from entering Indian markets" slogans. All this makes political decision making regarding India's agriculture sector a hot potato. Reforming any part of it involves hurting one or the other votebank. The politicians of course will continue their tapdance based on which ever constituency shouts the loudest on a given day. The adhoc policies that result from this will also continue for some more time to come. Something may give one day and change and reforms may then see the light of day. But don't hold your breadth and till then keep watching the dance and enjoy the show.

What’s happening to the Indian Rupee?

Background For a very long time, the Indian Rupee traveled in a single direction and this direction was almost always downwards. But, just like everything else that has changed in India in the last 15 years or so, this uni-directional movement of the currency has also changed. We now have a currency that moves both ways, and the movement is managed or regulated by the RBI (Reserve Bank of India). They even have a name for it. They call it the ‘managed float’. The only problem being that this has now become somewhat unmanageable. There are very few large economy countries that have successfully handled this ‘managed float’. Most major international currencies like the dollar, euro or the yen follow the ‘free float’ and are freely traded, with the market determining its value. Some other countries have the ‘fixed peg’ where their currency value is fixed to some other major currency which in recent times has usually been the dollar. The ‘Hong Kong dollar’ is a good example of this and has been pegged to the dollar since 1983. The RBI basically runs this ‘managed float’ by buying or selling dollars in the market to keep the rupee in a range that it likes. This range is usually decided based on the REER (Real effective exchange rate) basket of currencies. The REER indices is calculated by the RBI using a basket of currencies which are itself a function of a moving trade weighted average. The basket basically comprises of currencies that the Indian economy has a large trade with. Present Situation The problem for the RBI right now has been a deluge of dollars heading its way. FDI, FII, remittances & NRI investments have all brought in billions every week. The RBI throughout 2006-07 bought these dollars and issued rupees to keep the exchange rate in the band that it liked. The end result was that till about Feb 2007 it bought more than 25 billion $, taking its kitty last week past the 200 billion $ mark. This caused a deluge of liquidity in the Indian economy which then resulted in inflation. When the politics of inflation started getting hotter, it started raising interest rates to curb demand, which then brought in more foreign money attracted by the high interest rates. It has now decided that an appreciating rupee is the least of its problems and has let the currency market operate on its own. As of yesterday, this made the rupee break even the 42 barrier and end at about 41.80. The entire problem for the RBI stems from its attempt to manage the holy economic trinity of exchange rate stability, free flow of international capital and an autonomous monetary policy (which means the ability to target inflation). But, the trinity as they are, pull in different directions making it next to impossible to achieve any one without straining one of the others. What Next Trying to second guess the market is hazardous, but I'm going to try anyway. The RBI is now under tremendous pressure from the export lobby to intervene and stop the rupee from appreciating. It simultaneously is also under pressure from the political wing regarding inflation, which means it can't buy those flood of dollars without adding liquidity to the inflation fire. The other tempting option is to buy those dollars or at least some of them and then impound the resulting rupee liquidity by hiking the CRR (cash reserve ratio) of the banks. It has already done this a few times this year and the banks have responded by raising interest rates! Not a good option anymore unless it wants to bring the economy to a standstill. Its best option will be to ignore the export lobby for the time being and let the rupee find its level. While merchandise exports have slowed down, service exports (including IT/BPO) have continued to be extremely strong. This has kept the current account in control even though the merchandise trade deficit is burgeoning. But, I think imports (both oil and non-oil) which have continued to grow faster than merchandise exports will keep the rupee from appreciating more than the 41 mark. In fact, in the next 3 to 6 months time frame, it may even put pressure on the rupee to depreciate back to the 43 - 44 level. The bottom line is that the RBI just needs to concentrate on inflation and managing a soft landing for the hot economy and stop worrying about the rupee.