Loose monetary policies, weak currency are causes of India's inflation: Arnab Das
24 Mar 2010, 1501 hrs IST, ET Now
In an interview with ET Now, Arnab Das, MD & Head Research Strategy, Roubini Global Economics, talks about the causes of high inflation in
India and its development prospects.
Is there a chance that China will revalue its currency, the yuan?
Yes. There is a possibility of a moderate revaluation, not enough to change the overall story of global imbalances and Chinese surpluses, but enough to start the process, probably significantly less than what happened against the dollar for the Chinese renminbi between 2005 and 2008 when the bilateral exchange rate was appreciating by about 5% or 6% a year. It may be something half that or 3% to 4% a year, something like that. It may be less appreciation in a real trade renminbi than in the bilateral cost with the dollar. Once the Chinese start moving, the rest of emerging Asia will be more willing to move because until this point nobody wants to lose competitiveness in market share relative to China, which is already a super competitive economy with super competitive exchange rate.
Let us talk about carry trade, which happens when an investor borrows in a low interest rate currency and then invests in a higher yielding currency. Your prediction earlier this year was that carry trade, which has been on pause because of a strengthening dollar, will resume and the focus will shift to Asia. Do you still hold on to that view?
Yes. On the long side of the carry trade will be emerging market countries and their currencies and on the funding side will be probably once again the dollar in the second half of the year and quite possibly the yen as well. The argument for euro-funded or even Sterling-funded carry trades is rising. Basically, what needs to happen is a global exchange rate realignment where the currencies of high income countries need to depreciate against the currencies of middle income countries in emerging markets. That’s bound to happen one way or the other. Either it’s going to happen through inflation, which is what seems to be taking place now with inflation in India picking up. So, either the real exchange rates are going to appreciate through inflation or emerging market countries are going to grasp the nettle and say we need to keep economic stability so we will allow some amount of currency strength. But we think that the latter will happen. So what happen is like what I said before interest rates will rise, currencies will rise and this will be good for the performance sort of the Fex and may be not so good for equities which have had a very strong bull run as I am sure you know vast emerging markets last year and end of this year as well because these policies are disinflationary.
You mentioned inflation in India now it was very high at 9.89% in February, highest in 16 months. Do you think inflation will be India’s No. 1 macroeconomic headache in 2010?
Yes. The problem in India is that the policy response in some sense has been too successful. So, even though there was a very poor monsoon, growth was very high and industrial production has been surging. Perhaps the stimulus in India has been too strong and some of it needs to be withdrawn. Perhaps some of the inflation, particularly with regards to food, is coming from the weak monsoon and the effect that has had, nevertheless you have this problem of food inflation around the world and partly, it reflects base effect because a year ago, the world economy was sort of going down the tubes all over the place. So, part of there is base effect, but part of it is undoubtedly about monetary conditions being too loose, so currency is being too weak and interest rates being too low.
There is some residual concern of private investments in India, following the government’s Budget and its very large borrowing plan. Do you share those concerns? Do you think the government is just going to borrow so much in the private sector will have very little?
Around the world we have this problem that budget deficits and public debt are too high. This is perhaps less of a problem in India and in emerging markets than in the Western world. There is some degree of fiscal consolidation painted into the budget and perhaps not as much as people might have hoped, but times are pretty good in India and it’s tough to get governments and populations to make tough decisions when times were good. So, taken all in all, fiscal policy could be stronger but India is not the biggest offender as far as the deficit is concerned. Public debt is very high in India but it’s financed at home through banks that are substantially state-controlled. So, we don’t see a financing problem for India in the foreseeable future. We would like to see more fiscal consolidation; if that happens, it might allow for an easier monetary stance and otherwise because the fiscal consolidation would be disinflationary perhaps on its own and that would be a better sort of environment for sustainable growth in a longer term.
India is once again witnessing strong inflows from foreign institutional investors. So you think this will sustain because we did see a pause for a little while and what will be the trigger here? Do you expect strong earnings growth going forward?
Yes. The expectation of institutional investors around the world has become very similar to ours where that was not already the case. And the expectation is that the developed world will grow more slowly and emerging market countries will quickly in relative terms than in the past and in particular the largest emerging market countries with the strongest domestic demand will grow the fastest and in some sense the best. So, in the case of big emerging market countries, say the BRICs and some other systemically important emerging market countries, India and Brazil stand out as offering the strongest combination of domestically charged growth and growth at or even above potential in both countries. In the case of China, it is a bit complicated because exports have been a very big driver of Chinese growth, much bigger than in many other countries including India in the recent past. Now, its fiscal policy and infrastructure and other forms of investment that have been driving growth as exports have taken a backseat, so the longer term question in China remains can pass from export-led growth to domestically led growth and secondly can it pass from stimulus to consumption and household demand in particular. That question doesn’t need to be answered in India. There is plenty of evidence over a period of years that it is a big driver of growth in India, together with investment taking up more of the burden. So, it looks to us that the policy mix in India and the growth mix is somewhat better balanced and makes more sense for the world than that in the case of China.
What do you think of IMF Chief Economist’s idea of moving to a higher inflation target, say, 4%, instead of 2% in the developed world? The Europeans have slammed the proposal, but do you think there is merit in this proposal from the IMF?
The European Central Bank, which is substantially dominated by the Deutsche Bundesbank, would of course slam such a proposal because the history of Germany is one of hyperinflation and economic chaos. So, of course Germany and much of Europe will be strongly against that. The idea of adjusting inflation targets temporarily is a change in the orthodoxy. The more fundamental issue is that inflation targeting per se hasn’t worked to ensure, let’s call it, financial stability. Even though there was economic stability where inflation targeting was properly pursued, there wasn’t financial stability around those over lending, over borrowing and of course we know what the chaos is that resulted from that. So, temporary increases in the inflation rate to deal with the current problem may help in some countries, but really what we need to deal with is to improve the overall framework of central banking and financial sector regulation and fiscal policy and interaction betweens the macro and micro issues in governance and in incentives in the financial sector. All kinds of profound issues need to be dealt with and probably some sort of branch for forum needs to take place across the financial sector and the western world starting with the United States. Inflation targeting or changing the inflation targets is not going to solve that problem.
Finally, what do you think the next big bubble is going to be — emerging market equities, real estate or what?
We are already moving in that direction in the EM equity space and in the real estate space in many countries. It will probably continue to be the case that those bubbles form and develop. In our view of the world, what we see going forward is again this part of the world a high income world where interest rates will be at or near zero and money will be not only free but plentiful and emerging market countries where monetary conditions will need to be tightened. So, as monetary conditions are tightened emerging, market countries are going to allow their exchange rates to appreciate but only somewhat, probably not enough to prevent the inflation of further asset price trends and booms and even a bubble in many cases. Eventually, those bubbles are going to result in a deterioration in emerging market balance sheets. There probably will be credit booms in some countries particularly in countries with lower savings rates will become more vulnerable as the balance sheets in the developed world are repaired and then eventually monetary conditions need to be normalised in the United States and Western Europe. We think we are many months, if not some years, away from that happening, but it will happen eventually or at least we should hope it will happen and at that point there may be bursting of those bubbles that are now forming in emerging markets.
24 Mar 2010, 1501 hrs IST, ET Now
In an interview with ET Now, Arnab Das, MD & Head Research Strategy, Roubini Global Economics, talks about the causes of high inflation in
India and its development prospects.
Is there a chance that China will revalue its currency, the yuan?
Yes. There is a possibility of a moderate revaluation, not enough to change the overall story of global imbalances and Chinese surpluses, but enough to start the process, probably significantly less than what happened against the dollar for the Chinese renminbi between 2005 and 2008 when the bilateral exchange rate was appreciating by about 5% or 6% a year. It may be something half that or 3% to 4% a year, something like that. It may be less appreciation in a real trade renminbi than in the bilateral cost with the dollar. Once the Chinese start moving, the rest of emerging Asia will be more willing to move because until this point nobody wants to lose competitiveness in market share relative to China, which is already a super competitive economy with super competitive exchange rate.
Let us talk about carry trade, which happens when an investor borrows in a low interest rate currency and then invests in a higher yielding currency. Your prediction earlier this year was that carry trade, which has been on pause because of a strengthening dollar, will resume and the focus will shift to Asia. Do you still hold on to that view?
Yes. On the long side of the carry trade will be emerging market countries and their currencies and on the funding side will be probably once again the dollar in the second half of the year and quite possibly the yen as well. The argument for euro-funded or even Sterling-funded carry trades is rising. Basically, what needs to happen is a global exchange rate realignment where the currencies of high income countries need to depreciate against the currencies of middle income countries in emerging markets. That’s bound to happen one way or the other. Either it’s going to happen through inflation, which is what seems to be taking place now with inflation in India picking up. So, either the real exchange rates are going to appreciate through inflation or emerging market countries are going to grasp the nettle and say we need to keep economic stability so we will allow some amount of currency strength. But we think that the latter will happen. So what happen is like what I said before interest rates will rise, currencies will rise and this will be good for the performance sort of the Fex and may be not so good for equities which have had a very strong bull run as I am sure you know vast emerging markets last year and end of this year as well because these policies are disinflationary.
You mentioned inflation in India now it was very high at 9.89% in February, highest in 16 months. Do you think inflation will be India’s No. 1 macroeconomic headache in 2010?
Yes. The problem in India is that the policy response in some sense has been too successful. So, even though there was a very poor monsoon, growth was very high and industrial production has been surging. Perhaps the stimulus in India has been too strong and some of it needs to be withdrawn. Perhaps some of the inflation, particularly with regards to food, is coming from the weak monsoon and the effect that has had, nevertheless you have this problem of food inflation around the world and partly, it reflects base effect because a year ago, the world economy was sort of going down the tubes all over the place. So, part of there is base effect, but part of it is undoubtedly about monetary conditions being too loose, so currency is being too weak and interest rates being too low.
There is some residual concern of private investments in India, following the government’s Budget and its very large borrowing plan. Do you share those concerns? Do you think the government is just going to borrow so much in the private sector will have very little?
Around the world we have this problem that budget deficits and public debt are too high. This is perhaps less of a problem in India and in emerging markets than in the Western world. There is some degree of fiscal consolidation painted into the budget and perhaps not as much as people might have hoped, but times are pretty good in India and it’s tough to get governments and populations to make tough decisions when times were good. So, taken all in all, fiscal policy could be stronger but India is not the biggest offender as far as the deficit is concerned. Public debt is very high in India but it’s financed at home through banks that are substantially state-controlled. So, we don’t see a financing problem for India in the foreseeable future. We would like to see more fiscal consolidation; if that happens, it might allow for an easier monetary stance and otherwise because the fiscal consolidation would be disinflationary perhaps on its own and that would be a better sort of environment for sustainable growth in a longer term.
India is once again witnessing strong inflows from foreign institutional investors. So you think this will sustain because we did see a pause for a little while and what will be the trigger here? Do you expect strong earnings growth going forward?
Yes. The expectation of institutional investors around the world has become very similar to ours where that was not already the case. And the expectation is that the developed world will grow more slowly and emerging market countries will quickly in relative terms than in the past and in particular the largest emerging market countries with the strongest domestic demand will grow the fastest and in some sense the best. So, in the case of big emerging market countries, say the BRICs and some other systemically important emerging market countries, India and Brazil stand out as offering the strongest combination of domestically charged growth and growth at or even above potential in both countries. In the case of China, it is a bit complicated because exports have been a very big driver of Chinese growth, much bigger than in many other countries including India in the recent past. Now, its fiscal policy and infrastructure and other forms of investment that have been driving growth as exports have taken a backseat, so the longer term question in China remains can pass from export-led growth to domestically led growth and secondly can it pass from stimulus to consumption and household demand in particular. That question doesn’t need to be answered in India. There is plenty of evidence over a period of years that it is a big driver of growth in India, together with investment taking up more of the burden. So, it looks to us that the policy mix in India and the growth mix is somewhat better balanced and makes more sense for the world than that in the case of China.
What do you think of IMF Chief Economist’s idea of moving to a higher inflation target, say, 4%, instead of 2% in the developed world? The Europeans have slammed the proposal, but do you think there is merit in this proposal from the IMF?
The European Central Bank, which is substantially dominated by the Deutsche Bundesbank, would of course slam such a proposal because the history of Germany is one of hyperinflation and economic chaos. So, of course Germany and much of Europe will be strongly against that. The idea of adjusting inflation targets temporarily is a change in the orthodoxy. The more fundamental issue is that inflation targeting per se hasn’t worked to ensure, let’s call it, financial stability. Even though there was economic stability where inflation targeting was properly pursued, there wasn’t financial stability around those over lending, over borrowing and of course we know what the chaos is that resulted from that. So, temporary increases in the inflation rate to deal with the current problem may help in some countries, but really what we need to deal with is to improve the overall framework of central banking and financial sector regulation and fiscal policy and interaction betweens the macro and micro issues in governance and in incentives in the financial sector. All kinds of profound issues need to be dealt with and probably some sort of branch for forum needs to take place across the financial sector and the western world starting with the United States. Inflation targeting or changing the inflation targets is not going to solve that problem.
Finally, what do you think the next big bubble is going to be — emerging market equities, real estate or what?
We are already moving in that direction in the EM equity space and in the real estate space in many countries. It will probably continue to be the case that those bubbles form and develop. In our view of the world, what we see going forward is again this part of the world a high income world where interest rates will be at or near zero and money will be not only free but plentiful and emerging market countries where monetary conditions will need to be tightened. So, as monetary conditions are tightened emerging, market countries are going to allow their exchange rates to appreciate but only somewhat, probably not enough to prevent the inflation of further asset price trends and booms and even a bubble in many cases. Eventually, those bubbles are going to result in a deterioration in emerging market balance sheets. There probably will be credit booms in some countries particularly in countries with lower savings rates will become more vulnerable as the balance sheets in the developed world are repaired and then eventually monetary conditions need to be normalised in the United States and Western Europe. We think we are many months, if not some years, away from that happening, but it will happen eventually or at least we should hope it will happen and at that point there may be bursting of those bubbles that are now forming in emerging markets.