Demonetization: Gearing up for Policy Response

Impact on GDP growth of Government's recent Demonetization move: India's Revised GDP estimates for FY17 and FY18 have been published by at-least two Institutions and a similar exercise is on with feverish pace at most Banks, Rating agencies, Brokerages and Research think tanks. The revisions are not flattering and the first such published study estimates FY17 GDP growth figures lower by 3.3% and by 1.5% in FY18(as compared to the previous GDP growth estimates prior to the demonetization). Another study pegs the estimated growth lower by 03-0.5% in FY17. While economists and think-tanks crunch the revised GDP numbers as above, we are also interested in the consequent impact on Inflation due to the estimated shock to growth. At the current CPI(October'16) rate of 4.20% , the estimates for CPI rates at the end of FY 17 and FY 18 for the various GDP shock scenarios are provided below:

So we are staring at CPI rate scenarios ranging from 0.8% on the lower side to 3.6% on the upper side. While the upper side scenario is not a great concern, the lower end scenarios do not augur too well and call for concerted fiscal and monetary resuscitation to get economic growth back in shape. The Government(for the fiscal response), RBI and the Monetary Policy Committee(for the monetary response) must dispassionately examine the impact on economic growth and prepare for the most likely scenario that is likely to evolve in its best judgement. We shall not delve here into other relevant factors such as the external macro environment viz. Brexit, new US Administration and the like, but the range of estimates clearly indicates that for scenarios (a.) and (b.) above urgent fiscal and monetary action would be required. It is recognized that authorities have ample space to act in both areas. It must be then be utilized to the fullest and at the correct time, even preemptively if the scenarios (a) and (b) materialize/are most likely to materialize. Offcourse, a CPI print below 2% will trigger the framework between RBI and the Central Government which clearly says that CPI rate target is the range between 2% on the lower side and 6% on the higher side and must not be allowed to breach either. The necessity for fiscal and monetary resuscitation is made all the more urgent given the forecast of sharp drop in Credit in the above scenarios:

So clearly, in the scenarios (a) and (b) strong fiscal and monetary medicine would be urgently required. We did not have control on either the rollout or the implementation of the demonetization. But we must be prepared to respond to all the probable implications to this step in the near future to maintain strong economic growth.

Dilemma of the Central Banks: To push further NIRP?

Dilemma of the Central Banks: To push further NIRP?

There's no Zero Lower bound for Nominal interest rates. If you think Capitalism is in danger because of this sudden realisation, then unfortunately, it is too late a realisation. Realisation should have dawned earlier when Deflationary tendencies swept gradually across Japan, US, wide swaths of the EU and Governments left the job of resuscitation to Central Banks without taking any onus to timely rescue their respective economies in the fiscal sense of the act.

So now that the damage has been done, what is the way out of this? Glibly blaming NIRP(Negative Interest Rate Policy) is the easiest way out. NIRP is the symptom. Not the cause. Blaming the symptom is like saying your cough is to blame for the illness you have and not that virus that is causing the cough in the first place.

Banking Reforms
Japan had a Banking problem right from its Chaebol like cross holdings of its banks with its large corporates. US had a banking problem in a great many ways that are well documented leading into 2008. EU has a festering Banking problem which is in part also related to its ill conceived Currency/Monetary Union without a fiscal union in place.

So most of these negative interest rates issues actually arose from a faulty banking system and erroneous structures and incentives in place in all these jurisdictions facing this issue. That's the underlying cause. Don't just blame the symptom.

Spain and Ireland have done well to try and reform by setting up effective Bad banks and resolution mechanisms. Other nations such as Italy, France and even Germany should immediately start on the path of reforming their Banks. Japan has to reform its banking ownership structure- Big borrowers cannot also be owners of banks.

RBI outgoing Governor Raghuram Rajan has laid out a fairly full agenda for reforming the banking system in India. Missing is the bad bank piece which would gradually come about along with the other reforms that the RBI alongside the Indian Government is pursuing vigorously.

So should ECB and the BoJ cut rates further? Should they continue to expand their Balance sheets by way of commitment to more QE? It would be wonderful if the EU Council supports Governments such as the one in Italy to commit more to Fiscal support to their hard pressed economie. Secondly Banking reform must be carried out by Italy, France and Germany to fix the credit flow to the real sectors of the economy. NIRP and QE will work when both these issues are sorted out. Standalone QE and NIRP will not work. They must go hand in hand with Fiscal resuscitation and urgent Banking reforms.

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Bank of Japan - Negative Interest Rates-Good move

Bank of Japan has cut its benchmark rate to - 10 bps from 10 bps, a reduction of 20 bps and has left unchanged quantitative easing parameters.

This is immediate response perhaps to the negative index of industrial production data and to the overall sluggishness in the overall Japanese economy in the backdrop of falling Global trade.

As far as Monetary Policy goes this is most likely the best response from the BoJ at this point of time.

Increasing QE at this time would not have been helpful and indeed counterproductive at this point- so BoJ is again right by leaving that unchanged. 

Only Course left to FOMC- Reverse Stance Sooner rather than Later

All that was feared and written about on 24th August 2015 in "Rescuing a Deflationary World"(http://ageofdeflation.blogspot.in/2015/08/rescuing-deflationary-world.html) has ominously come to pass with the US Fed inexplicably raising rates in a haste in December accompanied with a simultaneous JPY carry trade unwind along with the breakage of the USD->CNY carry trade and as illustrated earlier in this blog the world economy is now truly on its knees.

The moot question is did the US Fed really see the ghost of inflation in December when the entire world actually stood perilously on the brink of deflation? And now that it is clear that the world is indeed in THE AGE OF DEFLATION what, pray, does the FOMC plan to do in the next two months? Study the data? Analyze? What analysis do we expect the captain of the sinking Titanic to do and indeed what analysis is on offer? No, please also do not expect the economic situation to revert back to square one to status quo prior to the December hike, if this hike is reversed - only that the route and fallout of the blunder will be slightly bearable to manage and implement a fix.

Why does the US Fed have to be answerable for China, Japan, ex-Asia et al? Because post the SE Asian crisis in 1998, most Emerging Economies' Central Banks have been maintaining a quasi dirty floating peg with the US$ using their respective FX reserves as the cushion to avert a repeat of the 1998 crisis and the result of this stratagem has been that post the 2008 crisis in the US when the US Fed slashed rates to almost zero, most Emerging Nations' Central Banks obediently* cut their REAL RATES to ZERO as well. In some cases , without naming individual Central Banks, the real rates were maintained at fairly high negative levels for much of 2009-2011 fuelling a rather huge credit binge driven asset price rally.
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* The reason is fairly obvious- If an Emerging economy were to maintain a higher real rate of interest higher than that of the US, the export driven economy(most Emerging economies are modelled on this in order to extract the purchasing power arbitrage or in other words the wage differential arbitrage between the Emerging economy worker and the American worker) would suffer as capital flows would make the exchange rate move adversely and make its exports uncompetitive. The saving grace was and is the FX reserves which would be expanded to keep the currency from appreciating too much against the greenback and thereby keeping the export driven model intact. The immediate 'obedient' fallout is that if due to any reason the US Fed has to reduce its real rates to 0, the hapless Emerging economy Central Bank has to follow suit and adjust its real rates at or below that 0 level which is what happened in the aftermath of the 2008 credit crisis. 

During the "taper tantrum" in 2013, when market was trying to price in the probability of the US Fed hiking rates, some emerging economies with weak current account and low FX Reserves were faced with the prospect of either higher domestic interest rates to attract foreign fund flows or a depreciating currency to maintain the export growth led model or deplete their FX reserves or a mix of these mechanisms. 
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In December 2015 when the US FOMC hiked rates in the absence of inflationary dangers, real US$ interest  rates started progressively moving higher as deflationary dangers manifested itself strongly. True to script, economies having weak current accounts or low FX reserves have had to face a brunt either through depreciation of the exchange rate or by raising the domestic interest rates or by depletion of their FX reserves(not an option for most emerging economy Central Banks though) or by a combination of either of these mechanisms.

Now add China and the Commodities complex in an overleveraged# setting to the above and the global economic growth model ignites to the mess we see today- a mega tragedy unfolding.
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#Not that you do not know this simple fact that we live in an era of over-leverage.... but the recent chain of events should not leave any doubt on the matter. Will not venture into a name and shame exercise as to who or what caused this sorry state of affairs, which is an exercise best left for another time or to another person (*a HISTORIAN?). China is a classic basket case of people trying to game the economic model of the state using leverage as an instrument and creating vast misallocation of capital into unproductive or wasteful activity.Take copper for example- in China with its ample land bank, inventory holding costs were low. US$ funding cost was cheap and because the PBOC created an artificial band between which the Renminbi could appreciate/depreciate, you could misuse this to import huge amounts of copper using borrowed dollars and inventory it for a short time while more leveraged buying of the commodity raised international prices- and then you sell it off in the domestic market at a profit because the RMB would not be allowed to :

(a) appreciate against the US$ beyond the band ensuring higher international prices always resulting in higher domestic prices,

(b)depreciate against the US$ beyond the band ensuring savings in hedging cost on the US$ Liability(referred to as USD->CNY carry trade) resulting in assured bumper profits attracting higher participation in a self fulfilling cycle as copper prices in particular and commodity prices in general kept rising -funded by leverage. 


This type of leveraged buying of commodities could not continue for ever as you ultimately need a willing and liquid buyer at the other end- which was ultimately found wanting because sooner someone realized that there was only so much requirement of wires to be extruded from the copper, and the rest had to be inventoried due to the limitation of actual end use.
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While we allow deleveraging to work its way through the system, what is required is a semblance of order and stability which can be used to gain time to resolve the rebalancing issues at hand. Had always maintained that the US Fed was mounted on a rather wild and fast horse in its quest to "normalise" rates and it has erred by a big margin and the time has come to either bailout of the Titanic by reversing course or if it still sticks to the "hike" bandwagon the boat will sink from hereon alongwith the entire bandwagon. 

Urgency of Creating a Bad Bank or The National Asset Management Co.(NAMCO)

The government today discussed the possibility of creating a Bad Bank or National Asset Management Co.(NAMCO) as per press reports available on the web http://economictimes.indiatimes.com/news/economy/policy/pm-narendra-modi-discusses-plan-to-set-up-a-national-asset-management-company/articleshow/48872058.cms

This is a welcome step. A few pointers that should be pertinent to discuss right away since the proposal is now getting seriously looked at as a very urgent measure to shore up the economy and derisk the NPA laden banking space.

1. Bad Banks have provided relief in the past to economies suffering from a credit meltdown post bursting of asset bubbles such as Germany (1980s), China (1990s), Sweden(1992),Ireland(2009),Netherlands(2011), Spain(2012), Portugal(2014), Latvia(2010).

2. Bad banks, in theory, operate on a short time frame project workflow basis for recovery of bad assets; while the good bank can continue to operate on a process driven manner and continue with the job of financial intermediation and credit allocation. The absence of bad assets on the books of good banks allows the good bank to concentrate fully on the evaluating credit proposals without the dead weight of past bad assets.

3. In practice, the threat of moral hazard is very real and the implementation must be such that it does not allow bad lending practices attain official sanction by the "Bad Bank" bailout. Also, small borrowers and small ticket lending that have gone bad must be kept out of the Bad Bank so that enough time is given to small borrowers to recover and repay.

4. So, Bad Bank is to be created out of the non-performing assets of the banking industry at book value or market value whichever is a fair price for the buyer(Bad Bank) and the seller(Original Bank). Needless to say, the original banks have to immediately recognize the value lost post default or due to non-repayment of the loan. But that is a given, or else shy would any investor put money in a Bad Bank and take the risk of losing capital because there is no certainty that defaulter/ borrower will repay the loan in the future.

5. The investor in the Bad Bank can be a private investor, original bank, or the Government or a combination of the three. Any model can work provided a workable and practical model of regulation and laws is put in place quickly and effectively. Even a model where the original bank forms a subsidiary bad bank at an arms length can work as evidenced by CitiBank recently in the US which has successfully implemented this model in the backdrop of the 2008 credit crisis. But the challenge in such cases is strong and effective regulatory oversight and regulatory framework.

6. The Bad Bank is not a going concern with a long life time like normal banks. It is at most a 4 - 5 year project where the investor is interested in recovering the money from the defaulters in a project management sense of business and exiting the business or handing it over to traditional banks who may be interested in buying the now-healthy not-so-Bad Bank.

That said, the creation of Bad banks will require new legislation- but examples in many nations abound as stated earlier above. These nations including Spain and Ireland had to undergo a thorough legislative law making and regulatory rule making before Bad Banks could become a reality and the challenge in the face of urgency is that these tasks be completed with great urgency.

Why should we display so much urgency? The global macroeconomic environment is nothing to be comfortable about, and ditto is the current state of our domestic banking system. If we are comfortable with dribbling the buck , then we can just stick around with the status quo and pray to God to make things better. But if we want to address the fact that every year 1 million young people are joining the workforce, then we can't just dribble- we must advance the game plan proactively to the next level without waiting for some crisis to goad us into action.

Rescuing a Deflationary World

We have had the very unusual spectacle of Asian Central Banks hypnotized by the snarl of the market cobra unleashing its fangs. While it is a natural human reaction to be thus mesmerized into inaction by a Cobra in the wild, there is little room for further inaction by Asian Central Bankers who stand similarly transfixed by an asset market collapse.

We had in a an earlier post (http://ageofdeflation.blogspot.in/2015/08/tantrum-not-us-fed-ahead.html) examined the chances of a USD,CNY and JPY carry trade unwind simultaneously as 1 in 31 and had cautioned that these odds are not so remote- all it needs is some senseless chores by guys with hands on monetary levers. And it has happened too soon for comfort. The US Fed seems hell bent on hiking rates at the same time when CNY and JPY carry trades are bursting. Now that's a sure recipe for disaster.

So what should Asian Central Banks do now that a simultaneous unwind of carry trades is in motion? Simple - ease monetary conditions domestically and let their respective currencies depreciate. Coupled with a possible weighing in of Govts' Fiscal support in the form of either Infrastructure investment or tax breaks for manufacturing and Services, the situation is imminently manageable. 

And what should the US Fed, BoJ and PBoC be doing? Firstly, the US Fed should stop playing the pantomime with the public. Every kid in primary school knows that his/her dad earns a lot less than 8 years ago- a wage deflationary spiral. So notwithstanding the Obama jobs boom, the take-home pay is deflating as efficiency gains outstrip hiring effects. So the lack of inflation is not surprising and the Fed should stop behaving as though if a rate hike does not go through in September it would mean a major loss in credibility. Secondly, the PBoC should finally achieve the lower bound in its targetted monetary policy rates to beat off a very likely deflation over the next 3 - 6 months. Thirdly the BoJ has to stabilize the Yen and ensure that the JPY does not overly strengthen against the US$ in order not to crush off the yen carry trade with precisely the wrong synchronous effect. The watchword here is stability. Reduce volatility. If the market must go down, let it go down 2% in a day for 5 days, rather than 10% in 1 day. 

Bad Bank/Good Bank

Now for some long term fixes- QUARANTINING of banking assets in Asian countries with pent-up credit booms now laid bare by an implosion into Non Performing Assets. The urgent need is for segregating banking assets into Good assets and Banking assets that have turned bad must be quarantined into a Bad Bank . It is important that there is a clear demarcation of bad assets into the single "Bad Bank" which will have separate recovery targets and capitalization. The rest of the "good banks" could only then function better with better credit targeting and allocation without the haunting fear of the ghosts of the past which irrationally constrains credit /raises cost of credit even to deserving borrowers with clean records. 

Government Investment into Non deflationary Infrastructure creation

In an era where every private entity is deleveraging, the State cannot also simultaneously deleverage. To rationalize take a simple case: In a closed economy, where there are only two agents, you and me, my spending is your earning and your spending is my earning. The entire world is a closed economy. If everybody is deleveraging, if unemployment is high, wherefrom economic growth will come? Hence the State has to invest in infrastructure such as Education, transportation, Tourism and the like that are inherently non-deflationary by borrowing at these historically low rates of sovereign bond yields. 

After forceful public investment lifts the economy from the deflation, the private sector develops the 'animal spirits' to restart investment- borrowing and hiring picks up. In this stronger phase of economic growth the private sector is more efficient than the public sector. Now here is where Keynes writings did not resolve issues because he wasn’t around to witness the decadence of public enterprise in the 1970's in the US/UK, and indeed in much of the globe including the USSR. However it was getting very obvious that in the 1970's, the size of the public sector was inefficient, gigantic and it was trying to borrow money from the same public resulting in crowding out of the more efficient private sector. The need of the hour then, was to cut down the size of the government and restrict the role of the state to only those areas where no other actor could qualitatively contribute. That's where Reagan and Thatcher came in, in the 1980's. But this is 2015. The situation is different. We are entering a global deflation. The only way out for a global recovery to gain ground is that Governments globally borrow massively and invest directly in the productive sectors of the economy. Roosevelt's "New Deal" needs to get replicated and for that to happen we need to really ignore traditional thinktanks like the IMF that had messed up in Latin America in the 80's and S.E. Asia in the late 90's and are now looking to repeat the same errors in 2015. Those who hold Reagan and Thatcher in great esteem can come in later, say in 2017, if by that time the global economy has been safely pulled out of the woods, and the private sector is getting back its mojo. By all means then-in 2017, dismantle the government and cut down upon activities that the private sector can do better. There will be lethargy on either ends of the economic cycle. Functioning democracies can tackle this type of lethargy and rent seeking on either ends of the cycle provided institutions are allowed to function the way they ought to.  

Of Global FX Devaluation Wars and Zero Sum Games

This is not a blame-fire write-up on China or any specific Country's FX devaluation policy because every country has done this at one point or the other in its history. Why blame China for a 3.5% CNY depreciation , for example, if Japan and the EU have both devalued their currencies by a flat 30-40% in the past couple of years. 

So this is not about naming and shaming FX de-valuers. This is about the nature of these beggar thy neighbour policies which are essentially Zero sum games. Over the last 5 years which country has truly benefited by playing the devaluation game? Name one country. I can't think of a single one. Because when the US is done in weakening the US$, the EU starts devaluing the EUR, and when both these guys are done, Japan says 'me too' and starts the same game- only to be followed famously by China now. So there's no great shakes in getting to devalue that filthy lucre that you print Mr. Central Banker so-and-so. What you can do, the next guy can overdo it, and destroy whatever little temporary benefit on the current account that you had derived previously. 

So we come to the central theme of this Global Devaluation Game- There's Nash equilibria out there- One of which is quite a no brainer - it happened way back in the 1930s and then exploded in 1939 in the form of a World War. Its all in the history books- well, Wiki is actually more accessible than those old books anyway!!

So why is everyone playing this game? Do they not know what is going on? Off course these guys are pretty smart. & Who told you that the great depression and the World War II was a very horrible time? Did you ask all those pumped up Bankers and Armament /Weapon producers who never sent their sons to fight in the War and die in those stupid bombings? The idea is to have a deflationary world- have unemployment - lots of it-so that young people are frustrated enough to believe and do anything preposterous - like frenziedly participating and dieing in another World War. That's the idea- Only a War, in this perverted scheme, can be suitably ignited to maximise the Keynesian pump priming that induces Sovereigns borrowing obscene sums of money to finance Wars run by Armaments /Weaponry Industry producing costly and immediately saleable weapons to kill those very young agitating to do something, anything. Problem solved. Big profits for the big guys and coffin caskets for everyone else. What a great time for these brainy chaps, no? Yes they are indeed very clever. Ask them why they have not used the record low sovereign bond yields in the G7 to borrow and invest in Infrastructure? They will speak some Hayekian non-sense like "Public borrowing crowds out private sector borrowing". Ask them where is the private sector borrowing now that Governments has actually desisted from investment? There's only share buybacks and cash surpluses maintained by private sector? Then they say, "Where is the climate for Investment? Governments need to create that climate first...", when it was these Hayekians who themselves stopped the Governments from actually doing so. You can easily understand why they say such dumb things. They are playing according to a script. They have the media, the smooth talking economists, everyone on their rolls. They are gunning for something big. Your money, your job, your son- & they will send across his body/news about his liquidation- one fine day, when they are done. Ask them why they will not allow Governments to borrow at close to zero costs and invest in supporting the economy through Infrastructure investments while they are ready to bankroll States/Nations in costly and meaningless Wars? Answer is profit margin. The margins are very poor when you do things the right way. But if you do it in the name of Lucifer, Well !! Well !! Stupendous margins in lending money at highest rates to war torn nations , not to mention the easy money that arms suppliers make on the rebound. Just add those coffins to the cost that simple folks will suffer BUT these smart guys will NOT INCUR.

This Nash equilibrium is being forced upon the world to benefit a very small circle of guys who will happily enjoy as millions and billions perish in another World War. 

So you get the drift- Ukraine, Afghanistan, Iran, Middle East, Africa- ISIS, Boko Haram etc. etc.

There's one Nash equilibrium which can be a regulated equilibrium where an optimal or a sub-optimal Nash equilibrium can be enforced if the G20 were to come together on issues like FX devaluation and trade. Since it is very clear that the Nash equilibrium discussed earlier is not in the interest of either Global peace or the World community, classical Game theory says that regulated behaviour amongst participants of the game can avoid a bad Nash equilibrium and move to another Nash equilibrium which is either optimal or close to optimal- but definitely atleast better than that bad Nash equilibrium. 

There has to be a global leadership away from the present one which takes on the onerous task of regulating the G20 away from the bad Nash Eq. This leadership is non-existent at present but the need is to get together and take the teetering world away from this bad Nash eq. Any effort is better than no effort- anything. 

Will leave you with three centrepiece blog extracts over the past 5 months- its worth a read to understand and read between the lines and join the obvious dots.

I. 20th May 2015

http://ageofdeflation.blogspot.in/2015/05/infrastructure-creation-fiscal-deficit.html

"...There is an urgent need to re- engineer strategy now that advanced economies have simultaneously launched an FX war on developing countries using zero lower bound interest rates and unconventional monetary policy. Developing economies cannot afford to join this zero sum game because their per capita incomes are very low compared to the developed economies. Ideally , all Governments in developed economies should use their prevalent low interest rates to borrow and supplement collapse in private demand by spending on infrastructure-both greenfield and maintenance of depreciating works. But these geniuses refuse to even consider such a policy relook and instead continue to debase their currencies in the hope of exporting their way out of deflation. The Nash equilibrium is very simple-Developing economies ape the same strategem and world spirals down a never ending FX war.

But there's a way out -There's another solution with superior payoffs as compared to the suboptimal Nash equilibrium above. Suppose developing countries that have the fiscal and inflationary room to increase government involvement in infrastructure spending, do so, then the resultant demand generation there can reinvigorate demand slowly elsewhere(especially in the developed world). This can serve a very useful purpose-Developed nations trying to export there way out of deflation will eventually export the deflation to developing countries if the latter fall into the Nash trap. Hence it is now in the interest of developing countries to search for demand generation internally. China best fits the bill with very healthy government finances and an Imminent deflation it wants to desperately avoid."

II. 10th June 15
http://ageofdeflation.blogspot.in/2015/06/the-real-malinvestment.html

"I can hear you say - But there's deflation already on in major economies, and higher investments at this stage will create more of the excess capacity and recreate stronger deflationary headwinds. Not if real unemployment is already in double digits and if the investment is likely to draw the pool of the unemployed or underemployed folks back to a decent job- which it will. These extra jobs/work that the investment creates will fuel demand immediately while the capacity creation comes only with a time lag - think 'Golden Gate bridge'. Since capacity creation comes only with a time lag post demand creation , as described above- the two are mutually reinforcing and there is no deflationary impact as is being feared by the Austrian school. ....

....but the underinvestment in most of the Western world is even worse and Chinese over-investment is a kid in size relative to the chimpanzee of the underinvestment pogrom that the 'Austrian' guys are doing to the great detriment of their respective economies. "

III. 18th March 2015
http://ageofdeflation.blogspot.in/2015/03/what-negative-sovereign-yields-signal.html

"...it is vey clear that in a deflationary environment private sector spending collapses and with negative yields supporting sovereign borrowing with beneficial fiscal spinoffs , the need of the hour is to sharply expand public investment in infrastructure,research and education. The answer is obvious-in the face of collapsing private sector demand only public sector demand can galvanize a deflating economy back to a modicum of health."