Thursday, January 31, 2008

Are regional trade agreements the right strategy?

This is one question you can expect to be asked either in Mains or in an interview. You can’t get a better answer for this question than from today’s op-ed by Prashant Goyal. Take a look at it here. But Some excerpts worth our noting follow.

Today 50% of world trade is under 200 RTAs and for countries like Mexico and Singapore almost 85% and 63% respectively of their global trade is under RTAs. In contrast, only around 30% of India’s global trade is under RTAs.

Today when our exports are around 14% of GDP and the trade-GDP ratio is almost 33%, our economy cannot afford this trade diversion. The effects of such diversion would be traumatic if India’s competitors were to conclude RTAs with India’s major trading partners.

The WTO negotiations are meandering. Even if the Doha round gets concluded, trade liberalisation is unlikely to be as ambitious as under RTAs owing to the divergent views and positions of 151 nations. RTA negotiations, in contrast, are faster, afford opportunity to seek tariff reduction in specific products of interest and also allow country-specific shielding of sensitive sectors.

Static benefits from RTAs include:

  • Trade creation through reduction in tariffs
  • Replacement of some domestic production from cheaper imports
  • Increased specialisation and division of labour in areas of comparative cost advantage
  • Increased consumer welfare because of reduction in prices

Dynamic benefits include:

  • Increased competition
  • Economies of scale
  • Stimulus to investment
  • Better utilisation of economic resources
  • Development and use of new technology
  • Increase in GDP because of efficient allocation of resources

Downside with RTAs:

The benefits, however, would be reduced to some extent due to trade diversion, lower-cost imports from efficient third country suppliers would be replaced by higher-cost goods from RTA members due to tariff preference for the latter. This reduces welfare by shifting production away from areas of comparative cost advantage.

A wider sweep of RTAs would help minimise this trade diversion impact. But, the Rules of Origin can never be perfect and the consequent trade deflection from non-members would to some extent neutralise the negative impact of this trade diversion.

Wednesday, January 30, 2008

RBI’s quarterly review of the monetary policy

The RBI Governor has kept the key rates unchanged in the recent review of the monetary policy. The key rates here include: Bank rate, CRR, Repo rate and Reverse repo rate. (Refer to the glossary or search our blogs for the definitions of these rates.)

Bank rate: 6%

Repo rate: 7.75%

Reverse repo rate: 6%

CRR: 7.5%

This has not gone down well with the expectations of the market, because everybody was expecting that RBI would reduce the rates in response to the US Federal reserve’s steep cut of the funds rate (the rate at which banks borrow/lend to each other). The Fed rate cut is seen as having sharpened the interest rate differentials between India and the US, leading to splendid arbitrate opportunity. This is expected to accentuate funds inflows into the country, leading to further rupee appreciation, subsequent sterilisation and the attendant fiscal costs.

But the RBI has stood its ground and the logic appears to be that there is no need for India to respond to US Fed’s actions at the moment. It felt there is no need for easing of our monetary policy in view of two factors:

  • There is adequate liquidity in our economy. The average reverse repo inflows are hovering around Rs. 13000 to 14,000 crores per day.
  • Global inflationary pressures have re-emerged.

For the moment, the RBI has found support from the FM also in its stand. But with the Fed rate cut bound to push more dollars into our economy, it is only a matter of time before it takes a hard look at our rates and possibly allow the appreciation of the rupee against the dollar.

Governor YV Reddy is known as a man of surprises. When the market expects him to act in a particular way, he never obliges it by acting in tune with its expectations.

So, my guess is that he will tinker with the rates sometime down the line but before the Annual Policy statement is presented in April. If he doesn’t do it, we can expect the rupee to strengthen against the dollar.

Am I venturing too far into the monetary expert’s domain? Yeah, I too have those doubts. But we lose nothing by being close watchers of the Governor’s moves.

Thursday, January 17, 2008

Floating vs. Fixed exchange rate system

Floating currency implies that the government of the currency concerned will not interfere with the exchange rate. But this never happens in reality. The question of floating vs. fixed can be better understood by us if we know some basics about what is known as the macroeconomic trilemma (or the impossible trinity). What this says is that at the most general level, policymakers in open economies are confronted with three typically desirable, yet contradictory, objectives:

1. to stabilize the exchange rate;
2. to enjoy free international capital mobility, and
3. to engage in a monetary policy oriented toward domestic goals.

Because only two out of the three objectives can be mutually consistent, policymakers must decide which one to give up. This is the trilemma.

So even a country that country professes that it has a floating exchange rate system does intervene often in the forex markets to obtain a 'desired' level of exchange rate. That is how countries end up having only a managed float. That is they will allow their currency to float (i.e., have its exchange rate with other currencies fluctuate according to market determined forces) within a certain acceptable upper and lower bands. Only when they fail to contain it within those bands does it really become a floating currency.

Thus, a fully floating currency is an idealistic situation. Free economies claim that their currency is floating. What they are referring to is their managed float only. Even the US does manage the dollar's exchange rate to a certain extent. It will be crying hoarse only when it is unable to control it beyond a point. That is why you see it cribbing about Chinese renminbi. While it sees that there will be lot of benefit for it in the renminbi's appreciation vis a vis the dollar, China sees it the other way round and follows a fixed exchange rate system. It will allow the renminbi to appreciate only at its chosen time.

A floating currency will allow the currency to be determined by pure market's demand-supply situation. At least the theory is that this will allow its goods and services to obtain the best/realistic prices in a given time period. In a fixed exchange rate system this will be government determined. The demand that the other country should follow the same system as that of the native currency will originate only when the host country of the currency sees that it is at a disadvantageous position.

To come back to the question about the pros and cons of the free vs floating exchange rate system. A floating exchange rate system will allow free flow of capital across the borders. But one should have the appetite to take risks that go along with it. That is if the currency depreciates/appreciates, one should be ready to face the consequences. This calls for lot of hedging abilities. In a fixed exchange rate system, while this risk is absent the rate can be altered by an administrative fiat. Then also one should be ready to face the consequences of depreciation/appreciation.

Tuesday, January 15, 2008

For a different world view

Remember James Wolfensohn? Yes, I am referring to the former Word Bank President. A piece written by him is printed in today’s ET. I strongly recommend reading it once. Do so here.

He suggests in his article that the notion of a divide between the rich developed north and the poor developing south has become obsolete in the context of globalization. The dynamic process of globalization has heralded the emergence of four inter-connected tiers of countries in the world.

The first tier comprises of the affluent countries – notably the US, EU, Australia and Japan. These countries which have relatively smaller populations and have contributed significantly for the world GDP in the last 50 years are now increasingly seeing a challenge from the second tier countries.

The second tier comprises of the emerging economies which account for roughly 50% of the world’s population. Though these had smaller growth rates in the region of 3.5%, they have learned how to integrate optimally with, and leverage the global economy to catalyse their development.

The third tier is made up of roughly some 50 middle income countries which continue to depend basically on their natural reserves. These ‘rentiers’ have not been able to translate rents of their natural resource wealth into sustained economic growth.

The fourth tier comprises of the laggards – the world’s poorest economies which continue to stagnate or decline economically. These are mostly located in the sub-Saharan Africa and they face crucial developmental challenges.

This emerging four tier world presents 3 key challenges:

First, is ensuring that the laggards no longer are left behind.

Second, is that the old powers need to accommodate the rise of globaliser economies by reforming the international order.

Lastly, the rise of the globalisers also has not been able to make any dent in the unequal world. The existing disparities in wealth or wealth creation capabilities continue to rise. Therefore, there is a need to create a more equitable world by scaling up the traditional levers of development such as trade, investment, aid and migration by reforming the global institutions.

Monday, January 14, 2008

The case for according MES (Market Economy Status) to China

It is another good piece in today’s ET that is worth our attention in the context of our PM’s ongoing visit to China. It makes a strong case for India’s according MES to China. Do you remember our noting on the subject earlier in our blogs? Look at it here. Then the case was that according such recognition is not in India’s interest. But today’s piece argues for according such status. Look at the reasons:

Not according the status to China on grounds of its extending subsidies to a whole range of sectors is not correct. While government subsidies do remain an issue in some industries in China, there is no evidence that this problem is endemic throughout large sectors of the Chinese economy. Also, other countries (such as Russia) which suffer from similar problems already enjoy a Market Economy Status.

Whether or not a country grants MES to China has minimal impact on trade balance with China. Take the US as an example. Even though the US has not granted MES to China, its trade deficit with China was $162 billion in 2004, $202 billion in 2005, and $232 billion in 2006. Thus, from China’s point of view, whether or not a country grants MES to it has little substantive value. The value is entirely “symbolic” and, as we know well, symbolism is a hugely valued commodity in China.

In any case, China will automatically get the Market Economy Status around 2015-16. Thus, for China, the symbolic value of getting MES goes down with each passing year. If India were to grant MES to China now (rather than after Japan, the US, or the EU have done so), the symbolic value to China will be much greater than if India were to be a mere follower.

Granting MES to China will not take away India’s rights to file legitimate anti-dumping cases. Even after China is granted MES, it has to provide verifiable information to the country filing an anti-dumping complaint. If such information is not provided, the latter retains the right to use the best information available, including third-country (surrogate) information. As it is, the current anti-dumping cases filed by India against China total less than 5% of China’s annual exports to India. In short, the substantive value of granting or not granting MES to China is insignificant not just for China but also for India. Yes, India will have a $9-10 billion trade deficit with China in 2007; however, MES has little if anything to do with the trade deficit.

Substance aside, if India were to grant MES to China before Japan, the US, and the EU do so, the symbolic value to China will be very high. If India is smart, it should exploit this opportunity to the maximum by getting quid-pro-quo concessions from China on issues that matter enormously to India (e.g., a settlement of the border disputes). In essence, India should look at MES for China as an issue whose salience rests almost totally in non-economic rather than economic domains.

Bank recapitalisation race

A very good article by UR Bhat in today’s ET on the subject is worth a read to comprehend economic developments that have far reaching global ramifications. Do look at it here.

Those of us not having the patience or time to go through the full article will be happy reading the following question-answer noting.

What is at the root of the massive write-downs that are witnessed in the global banking scene of late?

Bailing out bank sponsored off-balance sheet vehicles such as conduits, structured investment vehicles and money market funds beyond the formal legal obligation of the sponsoring bank was at the root of these massive write-downs.

This above development has far reaching implications for the shareholders, the accounting profession and also the banking regulators. Let’s look at them.

Shareholders: This was a risk that they never bargained for but still had to pay for in terms of value erosion.

Accounting profession: It would do well to revisit the level of disclosures and consider putting in place a reporting standard that requires disclosure on such qualitative and unquantifiable risks.

Regulators: They would need to have a rethink on the adequacy of risk capital that may need to factor the financial consequences of banks opting to take on such unenforceable obligations. Further, they need to ensure a fine balance between the dilution of credit creation function of banks which would result from any de-leveraging prescription, with the potential benefits of a healthier banking system.

Sunday, January 13, 2008

TIPS – Treasury Inflation Protected Securities

This is one more new concept for us to learn from a much respected columnist whose writings we keep following in our blogs.

Mythili Bhusnurmath explains us today about TIPS. Treasury Inflation Protected Securities. Advise you to read the full article once. Do so here.

What makes the concept interesting is the fact that interest incomes are not indexed to inflation. The result is that – if you are dependent on interest income only, then over a period of time you will be poorer than what you were some time ago.

Tips are a special type of government securities that offer investors protection from inflation. First issued in the US in 1997, (many other countries have similar instruments) this is how Tips works: the principal increases in line with inflation (as measured by the consumer price index) and decreases as prices fall.

When the instrument matures the investor is paid the inflation-adjusted principal or the original principal whichever is more. Since a Tips investor will never receive less than his original principal what this means is that the amount invested is protected.

The government has been reluctant to issue such bonds. Only index- linked bonds have been issued but these did not find many takers since only the capital (not interest) was protected. Ideally both must be protected.

Unfortunately, the government seems more intent on spending its energies on meaningless legislation in areas that are clearly outside its remit like the Senior Citizens (Maintenance, Protection and Welfare) Act (mandating that children look after their parents) than on providing senior citizens the wherewithal to protect themselves where it matters most, economically.

Those of you who have been debating strongly about the Senior Citizens Act, have much more ammo now, I guess. Go ahead and fire in the shout-box.

Saturday, January 12, 2008

What has Diwali got to do with the IIP – Index of Industrial Production?

IIP represents roughly one fourth of the total value of goods and services produced in the country. This makes it an important indicator worth monitoring periodically.

Industrial production grew 5.3% in November 2007 from a year earlier; its slowest this fiscal. The cumulative growth for the first 8 months of the fiscal stood at 9.2%.

Explaining that it is just a statistical blip rather than a reflection of any tangible slowdown in the economy, economists have come with the ‘Diwali effect’ theory.

They attribute the lower figure to a cut back in production in the festival month after aggressively building up inventory in the previous months to meet the demand, apart from a high base in November, 2006 when industrial output has risen 15.8%. During the festival month manufacturing plants are closed for a while.

Last year Diwali fell in October and so did the growth rate of the IIP to 4.5%. But the index rose sharply (15.8%) in the post festival month of November last year, setting up a spike from which to measure growth this November. The current fiscal saw Diwali being celebrated in November.

The high base effect associated with the falling of Diwali in one month last year and another this year, is being referred to as the Diwali effect.

Friday, January 11, 2008

The case for a new global financial order

The subprime mess in the US is slowly being seen as the failure of the existing global financial architecture. While the domestic financial systems of the rest of the world are monitored constantly, US seems to have been exempt from the process. It is now being debated whether or not it is a result of the lack of oversight / monitoring over the US system that led to this state of affairs.

The piece written by Rajrishi Singhal is very educative in this context. Take a look at it here. But some points worth our excerpting:

Following the Asian financial crisis, finance ministers and central bankers from 22 ‘systemically significant’ countries (including India) met in Washington DC in April 1998 to examine the functioning of the international financial system. This grouping has over time evolved into an important international forum. This grouping felt that the global capital markets and financial system could be further strengthened through action in five broad areas:

  • · Enhancing transparency and accountability
  • · Developing and assessing internationally accepted standards
  • · Strengthening domestic financial systems
  • · Involving private sector; and
  • · Modifying IMF’s financial facilities as well as other systemic issues for coordinated management of international financial crises.

While there were accusations of ‘crony capitalism’ hurled at the Asian economies, in the case of LTCM the US ensured that a group of rogue traders were bailed out under the garb of protecting the larger financial system. This time round too, the Fed has been flooding the market with liquidity to provide intemperate banks with not only additional capital, but also keep the inter-bank loan market afloat. Even the ECB (European Central Bank) pumped out half a trillion dollars to hydrate the European inter-bank market.

Only 10 years ago Korea was lectured about ‘structural change’ largely involving fiscal and monetary austerity. Post the Asian crisis, the term ‘bailing in’ the private sector – that is, ensuring that private investors also take a hit – became a buzzword. All this seems to have been forgotten now by the US and the developed world. The existing financial architecture seems designed purely for monitoring the emerging or developing economies.

It is in this context that two of the emerging developments need to be given a further thrust. One is the engagement of the five largest emerging economies – India, China, Brazil, Mexico and South Africa – with the developed economies for an enlarged role, the Heiligendamm Process. Second, is the reform of the voting rights in IMF and World Bank in favour of the developing and low-income countries.