Death by China?

“We will follow two simple rules – buy American, hire American”, said a defiant Donald Trump to a cheering public & an uncomfortable Washington Establishment, as he was sworn in as the 54^th President of the United States of America earlier this month. In his election victory, Trump smashed most expert forecasts, election pundits, opinion polls and the mainstream media narrative that had consistently projected his opponent as the favorite to win.

For those surprised by Trump’s victory, go no further than videos such as this, which might have played a major role in influencing public opinion during the U.S. Presidential elections. Claiming to be one of the most watched documentaries on Netflix for 3 years, the film narrates the story of an “increasingly destructive trade relationship” with China, which has led to the closure of over 50,000 American factories since China entered the WTO in 2001. The film blames China for causing loss of millions of jobs and accumulation of over $ 3 Trillion of U.S. debt to the “world’s largest totalitarian nation”. You can watch the full video here:

Loaded with terms such as “illegally subsidized exports” or “stealing jobs”, the import of the film is clear: Over the past decade and more, America has lost its ‘trade battle’ with China, and this loss is the result of an ‘unfair’ advantage the Chinese businesses get vis-à-vis their American counterparts. The film makes five basic allegations to corroborate its claims:

1. Polluting for Profits: Stringent environmental norms on U.S. manufacturing levy a heavy financial burden on U.S. businesses, but their Chinese competitors follow no such norms, giving them a cost advantage. 

2. Worker Abuse: China exploits its workers, forcing them to work for long hours often in inhuman conditions. This raises productivity per worker.

3. Currency manipulation: China pegs the value of the Yuan to the Dollar much below what it should be, which benefits its exporters.

4. Counterfeiting & Piracy: The Chinese are cheating on Patents, Trademarks and other such intellectual property.

5. Illegal Export Subsidies: The Chinese Government grants illegal export subsidies to its exporters

Due to all this, says the film, "they are cheating monumentally” by producing - sometimes even at 1/10^th the price of what it costs to produce in the United States. This has led to the death of American manufacturing. Almost 90% of all products sold at Wal-Mart are made in China. From garments to chopsticks, Christmas decorations to computers, and from printers to shoes – often it is almost impossible to find anything in an American store that is NOT made in China.

Really?

The “unfair” Chinese advantage is easy to "see" - and hence to blame, but things become complicated as the film moves on to discuss the role of American Multinational Corporations, who have themselves been at the forefront of outsourcing their manufacturing. From Apple to Caterpillar and IBM to GE and Cisco to Ford, every large American corporate worth its name has shifted it’s manufacturing to China to cut costs and improve profitability. Is it right for a Corporate Entity to cut domestic jobs to maximize profits? The film admits “profits Vs.jobs is at the root of America’s offshoring problem”. Sure corporate CEOs are focused on shareholder value, but isn’t this exactly the way it should be?

From time to time, I have seen the “blame China” narrative make its way into public sentiment. But most such narratives tell only one side of the story. Ask someone who bought his first big screen TV or furniture 50% cheaper, cheap imports have given their buyers a standard of living that was not possible earlier. When a foreign government pays you to buy toys or coffee making machines, is there really a cause to complain? As corporate America offshored jobs, profits got a boost, and despite the Wall Street engineered financial crisis of 2008, stock markets today are at an all time high, boosting the 401(k)s and mutual funds of ordinary Americans.

The documentary also erroneously links the $ 3 T U.S. government debt that the Chinese hold with cheap imports. Contrary to what is shown (and even otherwise believed); the large government debt actually represents a huge advantage the United States enjoys over other nations on account of the U.S. Dollar being the currency of international trade. Most exports worldwide are invoiced in U.S. Dollars, and the exporting country has no alternative but to park them in U.S. Government debt. The money thus represents a virtually free source of financing for the U.S. government. And as Jack Ma, founder of Alibaba pointed out recently, what the U.S. did with this money may tell the true story of why the jobs went where they went.

What about human rights? The film also mentions several human rights violations by China, such as the repression of the Falun Gong or Tibet, or its role in human organ trade or nuclear proliferation and aggressive military build-up. These are non-economic arguments that should not be used to color our judgment over cheap imports. 

It is also a contradiction to state that China’s lack of concern for the environment gives them an “unfair advantage”. Indeed, the documentary itself shows China paying the price for its monumental environmental neglect. It is well known that Chinese cities are now considered to be among the most polluted in the world.

Where are the solutions?

The ‘blame China’ rhetoric is a fallacy, and it best stands exposed when its time to offer solutions. While the documentary ends recommending “trade reform with China” and says that China should be held “accountable for human rights abuses”, it fails to come up with specifics. While pitching for ‘a strong manufacturing base for a prosperous future’, the film fails to tell you exactly how it can be achieved.

And this is no surprise.

For, China is just the symptom, the cause lies elsewhere. And this is pointed out in the film itself by Ralph Gomory, President Emeritus, Alfred P. Sloan foundation, when he says, “we are living beyond our means, we have artificially high standards of living”. Fix that, and everything will fall in place.

And that’s what President Donald Trump will need to do, to “Make America Great Again”.

Minimum Wage Laws: Substituting low wages with no wages

What do Minimum Wage Laws actually do to the people they try to protect? Click here to read my article on the subject.

Zero marks to the Zero Loss Theory

I was glad to come across the news that Shri. Kapil Sibal, Union Minister for Communications & I.T. has joined Twitter.  It is good that India’s political class is slowly but surely taking to the Social Media. This will help the political class and the citizenry to engage fruitfully with each other and bridge the gap between the two. Whether Shri. Sibal likes it or not, his name has been permanently etched in public memory with the Zero Loss Theory. Soon after Shri Sibal came on board, he was confronted with a question on the same: “Sir, please explain the zero loss theory in 140 characters” said a tweet. To this, Shri Sibal replied with the following: “Expenditure – Earnings = Loss, if expenditure is greater than earnings. Have you calculated earnings to calculate loss?”

One may recall that Shri. Chidambaram, the Union Minister of Finance also made a similar statement in the Coal Scam discussion. “…if the coal has not been mined, if coal remains buried in Mother Earth, where is the loss?” he was widely reported to have said. What Shri Sibal or Shri Chidambaram were saying is that since the beneficiaries of the alleged largesse have not monetized the giveaway, the spectrum or the coal mine, there is no loss.

In other words, if your car is stolen, there is no loss until the thief sells the car.

When put this way, the defect in the Zero Loss Theory becomes immediately apparent.

There is another related argument that is often made that needs to be demolished. It goes like this – ‘since government is not a profit making entity, assets need not always be sold to the highest bidder. Cheap spectrum can make cheap telephony available to the masses, and cheap coal can provide cheap electricity.’ This line of argument has even been made by the Prime Minister himself in the past. How far is this thinking valid?

The government owns nothing. It is a Trustee of the assets that belong to the citizens. Every sale of an asset below market price is a loss to the citizens and a net gain to the new asset owner. Once the asset is sold, neither the government nor its people control what the asset owner does with it. Hence selling assets cheap “in public interest” only results in losses that are certain and upfront, while the supposed benefits remain uncertain and in the future. The fallacy of this approach has been amply demonstrated in both the 2G and the Coal Scams.

Does this mean the government should always maximize revenue and profits?

No. Here, one needs to distinguish between selling assets and providing services. For example, the Railways can justifiably run at a loss – anyone who buys a ticket can benefit from the subsidy. The benefits cannot be monopolized. The assets remain with the government while the public benefit from the services. But the same cannot be said about selling spectrum or a coal mine, where neither the government nor the people can control what the asset owner does once the ownership is transferred. However, many a times this crucial point is missed.

I have not checked how many followers Shri. Sibal has acquired over Twitter. Does that mean he has Zero followers. Or does he, really?

Three myths about the "growth" debate

If one reads the country’s pink press or listens to the ‘experts’ appearing on television regularly, one might wonder why, with so many brains around to solve the country's problems, the problems are still there and not going away. The answer for this is not difficult to see. Given below are three common myths that surround the debate, making problem solving exercise an exercise in futility:

Myth # 1: GDP growth is utopia

No other economic statistic is probably as abused as “GDP growth”. Very few understand what (GDP) ‘growth’ is, and even fewer the limitations of this number. That is precisely why, probably, every politician worth his salt finds it a handy tool to misuse. GDP, or Gross Domestic Product, is the sum total of all output of final goods and services produced in the country in a given period. GDP growth then, is the increase in this output, adjusted for inflation. GDP growth shows how much more the country has produced compared to a previous period, usually the year. All this is fine. 

However, it is rarely discussed that:

What matters is not the absolute GDP growth but per capita growth, especially when comparing GDP figures between two different countries. For example, U.S. GDP grew by 2.78 % between 2011 and 2012, while India’s GDP grew at 4.99 %, faster than that of the U.S. However, India’s per capita GDP actually fell from $ 1,534 in 2011 to $ 1,489 in 2012 while U.S.’ per capita GDP grew from $ 48,113 to $ 49,965. (Source: World Bank). Indians were thus worse off than they were the previous year. All talk about India being “…one of the fastest growing economies in the world…” is thus meaningless, because India's per capita figures almost invariably turn out to be much worse.

Then there are other factors to be considered such as the composition of this GDP growth. In India, government buys food grains every year at higher and higher prices through an administrative fiat (MSP) with tax payer money which then rots in government godowns. This production counts as GDP, but it never reaches the consumer. With his remaining money, the tax payer ends up buying the remaining foodgrains in the open market at inflated prices, because so much of legitimate supply has gone out of market.

In a healthy economy, higher GDP figure should be supported by two other characteristics – increase in productivity and increase in job creation. India’s average GDP growth between 1999-00 to 2004-05 was 5.76 % and between 2004-05 and 2009-10 was 8.73 %. But the number of jobs created between 1999-00 to 2004-05 was 60.70 million whereas between 2004-05 to 2009-10 was just 2.72 million (Source: Planning Commission).

GDP growth is thus just a statistic that needs to be taken with a fistful of salt. GDP growth is an outcome of a healthy economy, but it does not necessarily constitute proof of one.

Myth # 2: The growth – inflation paradox

This probably is the biggest myth of them all – that the Central Banks are perpetually facing a Catch–22 situation: if rates are reduced (or liquidity increased, which has the effect of lowering rates) to propel growth, inflation flares up and if rates are raised (or liquidity tightened) to control inflation, growth suffers.

Let’s get this straight here – Bank lending and borrowing (i.e. deposit) rates move in tandem. If you want lending rates to come down, deposit rates need to be lowered too. And deposit rates cannot be delinked from inflation rate. Interest is the time value of money. The way an economy grows is like this: interest rates get high enough to encourage savings; this encourages people to save more. The banks (and others such as insurance & pension funds etc) become flush with money. They then compete among themselves to lend, which brings down lending rates. This in turn encourages more consumption and capital investment, promoting growth.

Lower interest rates are thus a result of increased availability of capital, which in turn is a result of increased savings, which in turn is a result of higher income and low inflation! That’s how low interest rate induces growth. All the economies which have shown high growth rates in the past, such as Singapore or China or even India have done so on the back of a high savings rate. Countries which tried to grow through excess leveraging, such as those in Europe or the U.S. are facing problems today.

What happens if inflation rate is higher than the rates of return savers get (the so-called negative real interest rate)? If inflation is high, disposable incomes fall; inducing people to cut down on discretionary consumption. There is also a flight of capital to hard assets and speculative investments, causing asset price bubbles.

Myth # 3: Central Banks can cure all economic ills

The media pays too much attention to Central Bank actions. The Central Bank can only do this much, and nothing more. It has the mandate to maintain the value of the currency, to oversee (but not to run) the banks and to run the credit & payment system in the country. The fiscal policy, the trade policy, the industrial policy, the law and order, the availability of manpower and requisite skill sets, the legal framework, the ease of doing business – there are several factors that impact how the economy performs. Most of these are under government influence. Most of the times, governments make things worse, in the guise of ‘regulating’ them. You just can’t expect the Central Bank to have a magic wand which will make all sins of the government disappear and power the economy full throttle.

In a 2012 World Bank ranking of 185 countries on “Ease of Doing Business", India ranked 132^nd. The rankings rate countries on parameters such as starting a business, dealing with construction permits and enforcing contracts. Here is the latest example - a bill introduced in Indian Parliament to “regulate” street vendors will soon make it impossible for anyone to even sell peanuts on the streets. And we expect Central Bank to promote growth!

When you bust these myths, most of what appears in the pink press or the business channels on how to promote growth will cease to make any sense.

A bridge to nowhere

The Preamble of the Reserve Bank of India describes the basic functions of the Reserve Bank as "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage." The central bank, of course has other functions in addition to this, such as the manager of foreign exchange, acting as the banker to the government and a lender of the last resort to the banking system. Maintaining price stability however, has always been seen as the primary objective of any Central Bank in the world. As the incumbent Governor of the Reserve Bank Dr. D. Subbarao prepares to demit office after an eventful tenure, I took a look at his monetary policy actions and the impact they have had on some key indicators in the country.

Subbarao’s tenure at the Reserve Bank has been one of the most challenging of any RBI Governor’s in recent times. Within days of his taking office, financial crises struck the economies of the West. Giant institutions collapsed.  Credit markets froze. World trade came almost to a halt. Stock markets crashed. Commodities plunged. The recession that followed in the U.S. and Europe has been described as the worst since the Great Depression of 1932. Though not a direct party to the tumultuous events unfolding in the developed world, a rub-off effect on India was inevitable.

Subbarao’s tenure has also coincided with a leadership crisis at the centre in New Delhi. In the last few years, a profligate UPA-II sunk itself neck deep in corruption, mega scams hit the headlines, crony capitalism peaked, “policy paralysis” became the buzzword and economic reforms that started in the 1990s reversed, ironically by the same man who was hailed as the architect of those reforms earlier. A welfare state has emerged.

In such an environment, managing the country's monetary policy can be no easy task. The policy under Subbarao followed alternate bouts of easing and tightening liquidity in 'baby steps' of 0.25 to 0.50 percent each at intervals of a few months at a time.

Phase	Over a period	Action
Eased liquidity, lowered rates	Oct 08 – Feb 10	Reduced CRR by 4 % Reduced Repo by 4.25 %, Reverse Repo rate by 2.75 %
Squeezed liquidity, raised rates	Feb 10 – Jan 12	Raised CRR by 1 % Raised Repo, Reverse Repo rate by 3.50 %
Eased liquidity, lowered rates	Jan 12 – May 13	Reduced CRR by 2% Reduced Repo, Reverse Repo rate by 1.25 %

What effect, if any, have these steps had on the key indicators stated while embarking on these policy actions? Let us take a look at some of them

Consumer prices have risen more than 50 % in less than five years

Consumer prices have risen continuously, at almost a uniform rate in the last five years. Between October 2008 and June 2013, prices (as indicated by CPI-IW) are up more than 50 % i.e. more than ten percent per annum compounded. Whether Subbarao was tightening credit or easing liquidity, it has clearly had little impact on consumer prices. 

The Rupee has depreciated from Rs. 48 to a $ to Rs. 65 in less than 5 years 

After an initial period of stability, the currency has collapsed. Especially from August 2011 when it was trading at Rs.45, it has been a one way street for the Indian Rupee, trading at around Rs. 65 to a dollar at the time of this writing. It is instructive to note that the Rupee broke its long term trading range (between Rs.45 to 50) in end-2011, when it was clear that the tightening cycle has ended and rates would be lowered going forward. Subbarao reversed the rate cycle with a CRR cut in January 2012.

Industrial production has gone nowhere in the last three years

If the rationale for cutting interest rates starting January 2012 was to promote industrial growth, it has clearly not worked. The Index of Industrial Production has gone nowhere in the last three and a half years - it stood at 163.60 in January 2010 and stands at 164.3 in June 2013. Whether Subbarao was raising rates or lowering them, industry has stagnated. 

In retrospect, vacillating between the demand from industry for lower interest rates and the imperative to tame inflation, monetary policy went nowhere under Subbarao. The cycle of liquidity tightening was abandoned abruptly in January 2012, ostensibly under the pretext of taming inflation. But even the meager mitigation in wholesale inflation rate never reached the end consumers. By lowering interest rates too early, Subbarao clearly jumped the gun, aiding, if not entirely causing the currency collapse. 

A prolonged period of negative interest rates is the primary cause of India’s financial crisis today. Negative interest rates promote investment in hard assets like gold and real estate at the cost of financial assets. Negative interest rates induce excessive borrowing and investment in unviable projects. Negative interest rates cause a flight of capital and depreciate the currency. The high inflation in recent years, and the sharp depreciation of the Rupee is a direct consequence of the RBI’s reluctance to raise rates when the situation demanded. A hawkish RBI is necessary to counter government profligacy.

Ironically, and unfortunately, Subbarao has been blamed for precisely the opposite – for not lowering rates enough. In the media, he is often portrayed as the one taking on the mandarins of the North Block, on issues ranging from interest rates reduction to new bank licences. But the symptoms of the current crisis - high inflation and a depreciating currency - prove that interest rates need to be higher and not lower than what they are. Subbarao probably knew this, but in the wake of the misleading clamor for reducing rates from the industry, politicians, influential economists and the media, could not stand up to his beliefs with conviction. In the end, his policy actions could neither control inflation nor promote growth.

Subbarao took office in the midst of a global crisis. He is now leaving in the midst of a domestic one.

(Also read a related article here)

Why RBI needs to RAISE interest rates

On 16^th January 2013, speaking at an outreach programme of the Reserve Bank of India (RBI) at Lalpur Karauta village in the state of Uttar Pradesh, India, Governor Dr. D. Subbarao said this: "If you see the currency note, it is printed on it that 'I promise to pay the bearer the sum of Rs 100' and it has my signature as the RBI Governor. What does the promise and signature mean? It means that the RBI will control inflation and maintain its purchasing power". It is another matter that the stream of journalists present did not report this very important statement (see here, for example) when they filed their reports on the event. Either they did not really understand what the Governor said, or did not like what they heard.

If you read the pink press regularly, or watch one of those stock market channels masquerading as ‘business’ channels, you might be forgiven to think that the RBI Governor sits in his office holding a magic wand in his hand. All he needs to do is to waive the wand lower, and lo! All the country’s economic problems would be solved! This magic wand, the press might tell you, is called The Interest Rate. So much is the pressure from interested politicians, crony capitalists and the media on the Central Bank to reduce rates, that one would be inclined to believe that that’s all that is there to managing an economy.

Subbarao has a promise to keep - to maintain the purchasing power of our money

The truth however, is not so simple. When it comes to the interest rates, the mainstream media is not just wrong, it is preaching exactly the opposite. Let us therefore be clear – beginning to reduce interest rates right now will take the country on the path of ruin.

Let us understand why I am saying interest rates need to be raised.

Inflation is still running frighteningly high. As per the latest figures, Consumer Price inflation (CPI) is at 10.56 % per annum. Food prices have increased by 13.04 %, with several key ingredients such as oils & fats (16.73 %), vegetables (25.71 %), sugar (13.55 %) rising at a much faster pace. Being official figures, even these figures may be grossly understated. Prices of several items have as much as doubled in the past year. The index does not even include the dramatic increase in the prices of services like transport  and education.

Bank lending is already growing faster than deposits. For deposits to catch up, interest rates need to be raised. RBI has pointed this out in the last mid-quarter monetary policy review on 18^th December 2012. In December, borrowings from RBI’s LAF (Liquidity Adjustment Facility) reached highest level for the year at Rs.1.70 lakh crore and are still running high at almost Rs. 80,000 - 1 lakh crore this month (see this or  this). To put it simply, banks as a whole are lending more than what their deposit base justifies.

The high rate of inflation and the shortage of deposits with banks clearly point to a need to raise, and not lower interest rates. Even the slight dip in wholesale inflation rate (WPI) from 7.24 % to 7.18 % that is being bandied around is far higher than RBI's 'comfort level' of 4 - 5 %.

Lowering interest rates ignores the interests of savers completely; it presupposes that borrowers are the only ones interested in interest rates. Lowering interest rates punishes savers, rewards borrowers and encourages profligacy. An economy should be built on solid foundations of high savings rate, and not on high borrowings. If savings are high, plenty of money will be available for productive investment, and this in turn will cause rates to move lower. Low interest rates are thus an outcome of a healthy economy, lowering rates artificially cannot automatically lead to a healthy economy.

In its Financial Stability Report released last month, the RBI has stated that low real interest rates are causing diversion of savings to hard assets like property and gold. Lowering rates further will worsen this trend.

Raising rates strengthens the currency, something India badly needs to do. India’s foreign exchange problems are well known and need not be elaborated here.  At a time when the country is trying to attract foreign capital by opening up new sectors for foreign investment, what justifies discouraging domestic savings?

Lowering interest rates now will worsen these trends, causing a further rise in inflation, erosion of savings, flight of deposits from the banking system and weakening the currency.

Vested interest and sheer ignorance promotes the myth that somehow low interest rates are  ‘good’ and high rates ‘evil’. The debate in the mainstream media is so one-sided that the merits of raising the rates or keeping them high are not even discussed. The bogey of low industrial growth and high Non-Performing Assets (NPAs) is raised every time to oppose raising or justify lowering the rates. But industrial growth has been slow mainly because inflation is eating away into people’s savings, leaving people with little money to spend on other things. High NPAs have been a result of various factors like the policy mess (e.g. power sector), poor business plans (e.g. aviation) or simply, in the words of the Finance Minister himself, “poor lending decisions”, not to mention willful defaults and corruption (e.g. real estate). I have not come across any instance which points to high interest rates as the primary cause of an asset turning bad. The rates simply aren’t that high.  

If high interest rates are not a cause of the problem, lowering them cannot be the solution as well.

The villagers of Lalpur Karuata, like the rest of us, will soon know whether Subbarao keeps his promise.

Shooting the Messenger - India's Gold Imports (Part II)

(In this two-part series, we look at India's gold imports in the context of its foreign exchange problems. Click here for the first part of this article) 

But, aren’t gold imports, however small, a waste of money? After all, gold has no intrinsic value.

Fig. 3: World's Central Banks are sitting on huge Gold Reserves

Neither does paper money! Let us first look at some more points of data (Figure 3). It is known that all Central Banks are holding large reserves of Gold  as part of their foreign currency reserves. The adjacent table that shows that even those countries who are facing severe economic stress, are holding  large amounts of gold as part of their foreign exchange reserves. (Even China is playing catch up and is in fact set to emerge as the world’s largest gold importer)

Fig. 4: Central Banks have become net buyers in Gold in recent years

Not only are the Central Banks holding large quantities of Gold, but are increasing them further (see Figure 4). In 2012 too, Central Banks have remained net buyers of the yellow metal, as these reports suggest (click here or here). If gold had no intrinsic value, why are the Central Banks themselves, who supposedly understand money better than us, sitting on so much gold and buying more?

The fact is, Central Banks understand that gold is money, and money does not have intrinsic value. Your currency note derives its value from the promise of the Central Bank printed on it. Gold derives its value from the value attached to it by thousands of years of human civilization. To destroy value of paper money, you just need to print more money (to elaborate on this is beyond the scope of this article, but the interested reader can refer to this excellent article on inflation). To destroy value of gold, you need to change the subjective opinions of billions of people (and Central Banks) all over the world. The reader can decide what is easier.

Even India's Central Bank, which itself bought 200 tonnes of gold in 2009 had this to say last week: "Gold is easily accessible. It is a store of value, has no credit risk and is relatively liquid thereby incentivising many households to buy gold” (RBI's Financial Stability Report (FSR) released on 28^th December 2012). 

But gold has no cash flows, pays no interest or dividends and is risky to store.

A common argument made against gold, but gold is not an equity share at all. So aren't we comparing apples with oranges here? Gold is not an investment at all. Gold is money, gold is currency, gold is wealth. I would use the cash flow  argument only to evaluate an equity share, not gold. 

But of course, you can’t take a milligram of gold to the grocer to buy your stuff, right?

Right. Nobody disputes the need for paper (or digital, these days) money. This article should not be construed as an invesmtent advice, nor am I saying that gold prices will continue to rise perpetually. The purpose of this article is only to highlight that gold imports are nowhere as problematic as they are being made out to be and one needs a different perspective to understand gold.

Conclusion

It is estimated that Indian households own more than 17500 tonnes of gold accumulated over centuries of civilization. Despite two decades of economic reforms, it is pointed out that India’s equity investor population has actually shrunk – a surprising statistic given the importance the stock markets are attached to by policy makers and the media. Performance of mutual funds has been disappointing, to say the least, and double digit inflation has made investing in fixed income instruments a loss making proposition. Gold and property are the only assets where Indian people have seen their wealth grow. Since buying property needs deep pockets, gold has emerged as the only asset which people can accumulate in small quantities. In fact, in the FSR mentioned earlier, the RBI has admitted low interest rates have caused households to shift away from financial assets to physical assets and valuables such as gold. “Gold prices have increased the most in comparison with other assets and are significantly above the movement in WPI (i.e. inflation)” it said. It has proposed inflation indexed bonds as an option, which it hopes can reduce demand for gold.

Blaming gold imports suits the political class, as it shifts the blame of India’s economic ills away from its own mismanagement to the Indian public. But it is for us to analyze data, ask the right questions and make intelligent judgement. Gold imports are neither frighteningly high, nor the cause of India's currency problems. Nor are Indians alone in buying gold. If people are buying more gold, there are reasons for the same. Those reasons need to be addressed. Other avenues to park money need to be made more attractive. Raising taxes or banning imports will only encourage smuggling, punishing the honest and rewarding the dishonest. Key non-gold imports, such as oil or defence need to be reduced by increasing domestic production. Exports need to be increased by controlling inflation (since higher domestic costs reduce export competitiveness). Interest rates need to be increased, and should be higher than inflation rate, in order to encourage savings in financial assets like bank deposits. Until that happens, people will continue to buy gold, and for a good reason.

III

President Roosevelt’s order had permanently pegged the price of 1 oz. of gold at $ 35 and committed the U.S. government to exchange dollars for gold at this rate with anyone on demand. After World War II, backed by gold, the U.S. Dollar emerged as the primary currency of global trade. All international transactions and agreements, no matter between which two countries and what their currencies, came to be denominated in U.S.dollars. But thanks to inflation, the dollar continued to lose its value while gold held its own. By the early 1970s, it was clear that an ounce of gold was much more valuable than the $ 35 that the U.S. government paid for it. The demands on America to redeem dollars for gold increased dramatically. In 1971, faced with a run on its gold, President Nixon announced that it was ending the peg of the dollar to the gold, letting it float freely in international markets. In the next 10 years, the price of gold shot up more than 10 times to more than $ 400 per ounce and is trading at $ 1650 today.

Shooting the messenger - India's Gold imports (Part I)

I

On 5^th April 1933, citing difficult economic conditions, the then U.S. President Franklin Roosevelt signed a decree. The Executive Order 6102, as it was called, made it illegal for American citizens to possess gold (with certain exemptions). The Order specified a date, 1^st May 1933 to be precise, before which all citizens were required to deposit all the gold bullion held by them with the U.S. Treasury or face heavy penalties and / or imprisonment upto 10 years. The U.S. Government would pay $ 20.67 per oz (troy ounce, i.e. 31.10 grams, the then official gold exchange rate) for the gold, the Order said.

A few months after the Order, the President signed The Gold Reserve Act of 30^th January 1934, outlawing private possession of Gold and suddenly changing the price of gold to $ 35 an ounce. In effect, wealthy Americans, who had amassed huge amounts of gold over generations of hard work and entrepreneurship since the onset of American industrialization in the mid-nineteenth century were short cheated for millions of dollars by the government in the name of saving the country. Mind you, financial markets were not as well developed in those days as they are today, and gold was one of the primary means of wealth accumulation in the U.S. at that time.

II

“Steps were being taken to control the Current Account Deficit…there was a need to control gold imports…” said India’s Finance Minister Mr. P. Chidambaram at a meeting of the National Development Council on 27^th December 2012. "We are worried about gold imports. It is an unproductive instrument", Mr. Raghuram Rajan, Chief Economic Advisor to the Government of India had said earlier. 

Over the last few months, there has been a sustained campaign in the press about India’s ‘soaring’ gold imports. The government has raised taxes dramatically on gold, quadrupling the import duty rate, changing it  from specific to ad valorem, and doubling the excise duty on jewellery as well. “One of the primary drivers of the current-account deficit has been the growth of almost 50 percent in imports of gold and other precious metals in the first three quarters of this year,”  Mr. Pranab Mukherjee, the then Finance Minister had said earlier last year, before announcing the tax hikes. “I have been advised to strengthen the steps already taken to check this trend.” To cut a long story short, Indians are buying too much Gold, and that is causing problems in managing the economy, we are being repeatedly told.

It is therefore time to take a look at the numbers and check out the facts. Take a look at the data on gold imports given in figure 1 below:

Fig. 1: Ninety percent of India's imports are non Gold

 We observe that:

1. Gold imports were 9.26 % of India’s total imports in 2011-12. Ninety percent of India's imports are other than gold.

2. Imports were in the 5 – 6 % range till 2008-09 but increased after that, roughly the time when the rapid deterioration of the economy began.

3. There has been a dramatic increase in the price of gold in the last decade. Increase in the quantity of gold imported therefore, is more benign. (It is in the range of 7 - 8 % per annum)

Gold imports have thus increased only in line with the overall growth of the economy, with only a small uptick in the last 2-3 years. They are in fact expected to come down in the current year and the next. The brouhaha around gold imports therefore does not seem justified.

Don’t they cite some data whenever they blame gold imports?

Figure 2: India's CAD started deteriorating from 2004-05 itself

Most of the time, it is pointed out that gold imports are high as a percentage of Current Account Deficit (CAD, the excess of total imports to total exports). Read the Finance Minister's comment yesterday: ‎“Suppose gold imports had been one half of the actual level that would have meant that our ‎foreign exchange reserves would have increased by $10.5 billion,” Chidambaram said. “I would ‎therefore appeal to people to moderate the demand for gold, which leads to large imports of ‎gold.”  But this is a wrong metric to use, since it does not prove causation. As  Figure 2 shows, India’s current account started deteriorating as far back as 2004-05 itself, much before gold imports picked up. Current account deficit is caused not just by gold imports, but by all imports and all exports. The question is not why gold imports are rising, but why the CAD is rising. Contribution of gold imports to current account deficit is much smaller than what is made out to be.  In 2011-12, India's total imports were USD 607.158 billion and total exports were USD 529.003 billion. Gold imports were thus only 4.95 % of the total Foreign Trade of USD 1,136.161 billion, a very small portion, compared to other imports like petroleum or defence. Overall current account deficit on the other hand, has increased at 64 % p.a. in the last 7 years. 

  

But, aren't gold imports, however small, a waste of money? After all, gold has no intrinsic value.

We will look at these and other arguments in the next part of the article. 

(To be continued)

Beyond the obvious

Is allowing FDI in multi-brand Retail good for the country? What is the true impact of raising diesel prices or restricting LPG subsidy on the people? Should telecom spectrum and coal mines be auctioned to the highest bidder, or should they be allocated cheaply so that the price paid by the ultimate consumer (for telephone services and electricity) is kept low? Should rail fares be raised? Should the Central Bank reduce interest rates to stimulate industry and make loans cheaper? Should the government act against airlines who fleece passengers by charging exorbitant fares during peak season? Should the government explicitly promote export oriented industries that earn precious foreign exchange? Should cheap imports from countries like China be banned to protect domestic industry? Is the government right in spending thousands of crores on welfare schemes like MGNREGA? Questions such as these are debated daily, and are of interest not only to politicians and bureaucrats who decide on these, but also to citizens whose lives are affected.

How does one take a stand on all these? How does one decide what is right and what is wrong? How does one assess the impact of these decisions – beyond the immediate fallout that we can see (such as, for example, that one would pay more for diesel if diesel prices are raised)? Do these decisions have implications that are beyond the obvious? How do we know what will work out best for us in the long run?

“Economics in One Lesson” by Henry Hazlitt is a remarkable book by any means. Written in such a simple language that even a layman can understand, Hazlitt unravels the mysteries of economic decisions and their long run effects on the health of the economy and welfare in general. Hazlitt explains how markets work, how people behave, how governments decide and what they do to the very people they seek to assist. Hazlitt gives a framework that enables the reader to analyze the long run impact of such decisions, including that  which is not so obvious but nevertheless very important.

Hazlitt's remarkable book should
be compulsory reading for all

The book is divided into twenty five chapters, each dealing with a distinct topic such as taxation, effects of mechanization, import tariffs, export promotion, government price fixing, inflation, and so on. Hazlitt explains the basic principles underlying these actions and the impact of these on the economic activity as a result. Hazlitt uncovers not only that which is seen, but also that which is not seen. In Hazlitt’s own words, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely on one group but for all groups”

It is amazing how much ignorance about economic issues is prevalent even among the policymakers today. Take the following paragraph from the chapter on government price fixing, for example. You might want to read it in the context of the current mess in India’s Oil & Gas sector, but keep in mind that Hazlitt’s small book was written in 1946!

Hazlitt writes, and I quote, “We cannot hold the price of any commodity below its market level without in time bringing about two consequences. The first is to increase the demand for that commodity. Because the commodity is cheaper, people are both tempted to buy, and can afford to buy more of it. The second is to reduce supply of that commodity. Because people buy more, the accumulated supply is more quickly taken from the shelves of merchants. In addition to this, production of that commodity is discouraged. Profit margins are reduced or wiped out. Marginal producers are driven out of business….if we did nothing else, therefore, the consequence of fixing a maximum price of a particular commodity would be to bring about a shortage of that commodity. But this is precisely opposite of what the government regulators originally wanted to do…. Some of these consequences in time become apparent to the regulators, who then adopt various other devices and controls in an attempt to avert them. Among these devices are rationing, cost-control, subsidies and universal price fixing.” Hazlitt then goes on to systematically demolish each of these.

As we all know, relying on the promise of deregulation, billions of dollars were spent on all stages of the oil & gas value chain in India, from exploration to refining to pipelines to storage & distribution. But the country still doesn’t have enough of what it needs. Most of the capacity in the private sector has been shut or is on the verge of closure, the public sector survives on huge doles of support from tax payer’s money. People don't have enough of what they want and the private producers have all but fled, all because of faulty price fixing.

It is remarkable that such a storehouse of knowledge can be crunched in such a small book and explained so lucidly. This book should be compulsory reading for all the lawmakers who decide our future, and for all of us who choose them.

Why Socialism fails

Came across this interesting and instructive story recently:

An Economics Professor at a local University made a statement that he had never failed a single student before, but had recently failed an entire class. That class had insisted that socialism worked and with socialism, no one would be poor, and no one would be rich, a great equalizer.

The professor then said, “Ok, we will have an experiment in this class on the socialism principles. All grades will be averaged, and everyone will receive the same grade, no matter how one actually performs in the exam"

After the first test, the grades were averaged, and everyone got a “B”. The students who studied hard were a upset, and the students who studied little were happy. As the second test rolled around, the students who studied little studied even less, and the ones who had studied hard earlier took it easy too. The second test average was a “D”! No one was happy. When the third test rolled around, the average was an “F”.

As the tests proceeded, the scores never increased, as bickering, blame and name calling all resulted in hard feelings and no one would study for the benefit of others. By the end of the year, all failed.

The professor told them that socialism would ultimately fail because when the reward is great, the effort to succeed is great, but when the reward is not yours, no one will try or want to succeed.

Could not be any simpler than that.

Returns or Inflation?

Between July 2008 and today, the Indian Rupee has lost 40 % of its value.

Talk about rising prices, and discussion in the media inevitably revolves around the Inflation Rate. The Finance Minister talks about the Inflation Rate, so does the RBI Governor, the experts on TV channels and journos from the print & electronic media – all you get to hear from them is the Inflation Rate. Further, more often than not, they refer to the WPI (Wholesale Price Index), while what matters to the people is the CPI (Consumer Price Index). A meaningful analysis of how rising prices are hitting the venerated (just for namesake!) 'aam aadmi' is therefore, conspicuous by its absence. To understand why I say so, you first need to know what the problem with the Inflation Rate is.

This is what they show you - falling inflation (click to enlarge)

The Inflation Rate shows the difference between price of a commodity (or price index) over a period of one year. It compares the current price of a commodity with its price at the same point of time a  year ago. So if the price of loaf of bread was Rs.20 exactly one year back, and it is Rs. 22 today, we say inflation rate is 10 %. (Rs.2 over Rs.20).

But the inflation rate completely ignores prices more than one year away. If your perspective is long term, as it should be, the current inflation rate will tell you nothing about how prices have risen over a longer period of time. If prices double in a year, and remain where they are for another year, you will get an inflation rate of zero, though over a two year period, prices would have gone up by almost 50 % per annum. Therefore, while inflation rate has its uses, it is also important to look at the actual price index itself, to get a proper perspective on prices. Unfortunately, the media, and their  so-called experts are rarely interested in such finer details.

This is what the truth is - ever rising prices (click to enlarge)

Take a look at the news items, such as this or this or this Rarely will you find a mention of the actual price index. So I thought it would be worthwhile to see what was has happened to prices actually, rather than the inflation rate since July 2008. I used the Consumer Price Index (CPI), and not the Wholesale Price Index (WPI), since that is what matters the most to the people. What I found out was what I told you in the first sentence of this article – the Rupee has lost 40 % of its value in the last three & half years. The CPI (IW) which was at 143 on  31^st July, 2008 stood at 199 on 29^th February, 2012, almost 40 % higher. What does this mean? In simple terms, what ever Rs.100 could buy in July 2008 costs Rs.140 today. 

Now, if you were to adjust any of the current prices to this, you will get the real picture of price increase / decrease during the period. Adjust Sensex or the Nifty to this, and the indices which apparently have given a return of 24 % during this period actually end up with a loss of 11% ! Even property price rise has been very modest (19 % in 3 & 1/2 years) while Gold has performed the best.

As on	31-Jul-08	29-Feb-12	29-Feb-12*	Real Returns
CPI (IW)	143	199	143	0%
Sensex	14356	17753	12757	-11%
Nifty	4333	5385	3870	-11%
Gold@	12530	28599	20551	64%
Property#	117	193	139	19%

(* Inflation adjusted level) (@ MCX Spot price per 10 gms) (# NHB's Residex for Mumbai) (All Returns are absolute, not annualised)

To assess the price performance of anything over the long term, you need to deflate it with the price level. That is when you will get the real picture.   

Note: In 2011, the Government issued a new series using 2010 as the base. As per the new series, the inflation rate is 9.45% and 10.30% for Urban India in February and March 2012 respectively, even higher than what the above figures indicate. For want of adequate history, I have used the old series of CPI in my calculations above.