India vs. China :: Where does India stand in this battle?

In the late 1970s the communist government in China realised that the State Managed Enterprises, which were dominant in all sectors, were facing a severe shortage of funds. This prompted the economic reforms in China in the 1980's. The government had no intention of giving away its ownership in these sectors. Hence even though the public sector companies were not performing well, private ownership was fiercely opposed. The reforms enabled the inflow of foreign investment in China in the form of FDI and FII. This brought in the much needed capital in the country and China made sure that the capital was invested in the SMEs to sustain their growth. It gave many incentives to the foreign investors and lured them to making huge investments in China. Foreign enterprises were allowed to set up their manufacturing plants in China thus providing employment opportunities to the citizens. These reforms have ensured a high growth rate for China. The foreign investors have confidence in the economy and also in the governments resolve in continuing with the reforms.

In India the government was not against capitalism but against the flaws of capitalism. The inflow of the foreign money was opposed not to protect its public sector companies but to protect the small scale Indian industries that provided occupation to many Indians. The government never tried to take control of all the sectors and private companies always found a way to work in sectors where the PSU's had no reach. The economic reforms were introduced in India in the year 1991 due to the lack of funds with the government. Unlike the reforms in China, the Indian government reduced its control on PSUs to just three sectors (Defense, Nuclear power and Railways) and encouraged private ownership in all the other sectors. It relinquished the price control to the open markets and regulated the capital markets to ensure transparency in the use of capital. It reduced bureaucratic procedures and made life easy for business. But it did not open the flood gates for FDI as China did. The FDI and FII were allowed to invest in the country but in limited capacity.

Due to these policies the home grown entrepreneurs and industries were encouraged and the government went a step further by indirectly providing limited protection against the foreign competition. This allowed the Indian industries in high technology sectors (Infosys and Biocon) to flourish and compete against their counterparts in Europe and America. As against this, the Chinese government continued to be liberal with the foreign private ownership while at the same time creating legal and regulatory barriers for private ownership at home so that they could not pose a challenge to the SOE. It used the foreign capital to obtain economies of scale in manufacturing this making it the world’s factory.

Can India surpass China? India has a long way to go before it can really challenge China. Problems like excessive bureaucracy and slow implementation of policies need to be solved by making the political class more responsible. India has many problems other than economic growth like ethnic and religious tensions, a dispute with Pakistan over Kashmir, its internal political instability, etc. There are few incentives for FDI and FII and the poor labor policies, infrastructure and slow judiciary are a concern for the investors. The manufacturing sector and agriculture need a boost so that the long term growth of the country can be ensured. China has its own problems like the control of the provincial and local governments over vast majority of capital-hungry enterprises which creates an unsolvable collusion between regulators and the state's ownership interests. China doesn’t have an independent judiciary. Also the banking sector in china is extremely week as the banks are technically insolvable. This has led to a lack of home capital and excessive dependence on FDI.

The capital markets in India have flourished making it possible for the Indian firms with solid growth and good prospects to raise money as and when needed. The Indian firms have only a small percentage of funding coming from the operating profits while the rest comes from the markets. The banks in India have not done the same mistakes as the Chinese banks and so the banking system is robust. However it needs to have more depth to satiate the need of the growing industry demands. With the government making regulations less stringent for the foreign investors and the NRI to invest in India and with steady economic reforms and the much needed political will, India seems poised to surpass China economically and politically to become the next superpower.

-Mayank

1991-2007 - The Economic Reforms - FDI perspective

After independence, India chose to be a closed economy where all the investments would be planned so that welfare of the masses would be ensured rather than that of a handful few. India was unfavorable for investment with a low growth rate and gloomy prospects. This changed after tentative reforms were introduced in 1985 and then significant economic liberalization was carried out in 1991 by the congress government under the aegis of Dr. Manmohan Singh, the then Finance minister. The reforms were a reaction to the rapid rise in the fiscal deficits (8.5 % of the GDP) and low foreign reserves (~1Bn$) which had left the Indian government with little funds to run the country. The liberalization opened up the Indian economy towards the Foreign Direct Investment in many sectors and government restrictions and regulations were reduced (e.g. abolition of License Raj) to make the atmosphere conducive for business. The tax rates for businesses were reduced as an incentive. Also the trade policy was modulated to allow import of goods that were previously restricted increasing the competition in the local markets thus improving the efficiency of the Indian companies. The government also decided to remove its monopoly form 15 out of 18 sectors leaving its control only on Railways, Defense and Atomic energy.

These reforms resulted in an average growth rate of 6% in the decade 1991 - 2000. However towards the end of this period, growth in the services sector slowed down. The '.com' bubble had burst and the Indian IT companies were finding it increasingly difficult to distinguish themselves from the ailing companies in this sector. As a result the industries improved their efficiencies by a significant amount and by the end of 2003 the Indian IT companies were a leaner and fitter group. Also there was a tremendous improvement in the performance of production sector and the gradual implementation of the policy reforms had started to show results.

However since the last quarter of 2006, there has been a steep rise in the amount of FDI and FII in India. Good performance of Indian companies is one of the reasons but then this sudden influx needs an explanation. One of the important reasons is that in early 2007, the subprime crisis had been triggered in the US and nobody could predict the depth of the trouble. This uncertainty forced the foreign investors and India (along with other members of the BRIC) has been a favorable locations. The advantage with India is its less dependence on the US (around 20% of the GDP) and so a slowdown in the US economy will not have significant effects. Also it is considered that the growth in India is driven by its internal consumption and so it will be sustainable for a long time to come. The recent sellout by foreign investors in the Indian markets is a cause of worry but a good budget announcement in the month of Feb will definitely make the investors think twice before exiting India.

-Mayank

Is RBI wrong in stopping the Rupee from appreciating?

As far as the movement of rupee is concerned, the RBI (Reserve bank of India) follows a mixed policy in which it allows the rupee to move in a certain range and interferes only if it deviates from this range. This policy is also called as "Managed Float". As always, this policy has its supporters and its detractors and I fall in the latter category. Though the facts that I will put forward are true, the interpretation may vary from person to person.

What is meant by "Managed" and "Floating" policies? When a central bank interferes in the Foreign exchange market to keep its currency at a fixed level (e.g. China) it is called as a 'Managed' policy whereas if the currency is allowed to reach equilibrium on its own due to the market forces, it is called a 'Floating' policy.

Indian Industries have been performing exceedingly well in the past decade. The political stability and the consistent economic policies have made Indian industries extremely favored location for investment. There has been a huge inflow of FDI and FII from the US. Due to this the Rupee has been feeling pressure to appreciate against the USD. However the RBI has been frantically sucking out the dollars from the market and has been increasing the dollar reserves to stop rupee from appreciating.

How is a weak rupee bad? Due to this artificial weakening of rupee inflation rose to as high as 6% last year. When RBI sucks out the USD to increases its reserve, it has to pour out rupee in the market. This creates extra liquidity in the market and the value of rupee depreciates. This increases the inflation making daily needed items extremely costly. The people who were most affected by this were the poor who found it tough to survive even though the country was close to double digit growth figures. The gains of this growth were definitely not propagated to the poor.

Rising inflation has the capability of toppling governments. Well aware of this fact, the government has been pressurizing the RBI to bring changes in its monitory policy. The obvious solution in front of RBI was to increase the interest rates and to increase the Cash Reserve Ratio that the banks have to maintain. This sucked the liquidity out of the market controlling the inflation but at the same time slowing the economic growth considerably. November and December have seen considerable decrease in the growth of manufacturing and IT industries. This slowdown has been inappropriately tied to a slowdown in the US economy while it could actually be due to the hard stand taken by the RBI.

The obvious solution at this stage could be to leave the rupee movement alone and let the rupee appreciate. It will be a reflection of our growth and will improve the standard of living of the poor Indians. At the same time the RBI could reduce the interest rates thus easing the policies to pump the mush needed capital to maintain high growth rate.

-Mayank

Are the commodity Exchanges really helping the farmers?(5/2/2008)

What is a Commodity Exchange? A Commodity Exchange (similar to the stock exchange) is an association or a company or any other body organizing trading in commodities. The trading may be spot trading, future trading or options. Future trading is a kind of forward trading done in special exchanges. It is an important concept that can be explained with the help of following example: The price of Rice is say Rs 5000 per ton as on February 4th. A person X believes that the price of rice is going to increase and in August it will be say Rs. 5100 per ton. So he puts an order to buy one ton of rice at Rs 5000 in August from any other person who is willing to sell it at that price. The moment a seller is obtained the deal is completed and thus a future trade is done well in advance. Now there are two scenarios: if the price increases (as predicted) the X will make a profit or he will make a loss. The commodity market includes agricultural produce, metals, minerals, etc., however lets stick to the agricultural part in this discussion.
Where is the farmer in this whole process? The commodities market appears to be encouraging only speculative gambling involving the broker and the traders. It is not entirely true. The prices of the commodities are decided by the market forces just like in case of the stock prices of companies (the regulatory authorities can intervene). These price discoveries are based on factors like whether forecast, government policies on agriculture, the international demand, etc and they are hence they give the farmers a good estimate on what price he is most likely to get at that time in the future. This enables the farmers to make wise decisions about which crop to grow depending on the profitability of the crop and market demands of the future. The farmers get into deals with the buyers selling their produce even before the seeds are sown thus hedging against the risk of a prices falling in the future. The obvious doubt that arises is that what if the farmer gets into a deal at a lower price and the spot price in the market at the time of deal expiry is higher. In that case the farmer has the option to square up his position and sell the actual produce in the spot market at the higher price thus making even more profit.
The commodities exchanges in India are namely the National Commodities and Derivatives Exchange (NCDEX) and the Multi Commodity Exchange of India (MCX) started in 2003 and are regulated by the Forward Market Commission (FMC), a regulatory authority overseen by the Ministry of Consumer Affairs and Public Distribution, Govt. of India. The NCDEX currently facilitates the trading of around 50 commodities while the FMC facilitates for about 90 commodities with a daily turnover of around 2 Billion $.

Is it really uplifting the Indian farmer? Indian farming has its own problems of small farms (due to property division), lack of irrigation facilities, lack of know-how about the advancements in agriculture, etc. Most of the Indian farmers are extremely poor and cannot produce enough to trade in the exchanges. Also apart from a few states (Maharashtra, Punjab and Haryana), the farmers in other states do not have the means of communication to gain access to price dissemination of the goods in the markets and are hence still exploited by the traders. It is only the rich farmers who are actually benefiting out of these exchanges and the poor ones are still as isolated to the market as before. Also the price speculation tends to increase the prices of commodities; the perfect example is when due to inflationary pressure the regulators had to suspend trading of rice and wheat last year to prevent the prices from soaring after a significant rise.

If the real motive behind starting the commodities market is to help the farmers then the first step should be to consolidate Indian agriculture by reducing the percentage of population engaged in farming. This can be done by bringing industries in the villages and providing alternate job opportunities for the ultra poor farmers thus trimming the population based on agriculture for their living. With a lesser percentage of population involved, the benefits of this exchange will be truly realised.

-Mayank
5/2/2008

Effects of the Subprime market meltdown on India

If you have read the previous write-up, you would have realised by now that the current Indian Real estate situation looks very much similar to the one in US in 2004-05. A booming economy with the property rates soaring high and everyone wanting to get a piece of the pie. However the Indian banks do not have structured finance products (so far) like CDO, etc. that depend on the mortgage securities so the risk of amplifying the problem is low. However the subprime crisis has resulted in speculations about a recession in US.

How is the possibility of US recession going to affect India? Well, to start with, U.S has the largest customer base of Indian services companies and so with a slowdown in the US economy, there is going to be a slowdown in the demand for new and innovative services products making it tough for Indian IT industry to maintain high growth rates. Solution: The Indian companies must start diversifying the customer base by tapping Europe, China, Russia and South America. This will ensure that only a small percentage of the company turnover will depend on American clients.

The decoupling effort (minimize the dependency of Indian market on situation in US) will take a hit as FDI and FII from the US will increase (O). NOW THIS MAY SOUND CONFUSING. On one hand we say that the US investors are trying to bail out of their investments by selling off (as we saw in the recent market slump on Dalal Street) and on the other hand we say that FDI and FII will increase. How is that possible? The answer is as follows: The US Federal Reserve has decreased the interest rate to 3% while RBI is reluctant in reducing it even by a small margin in order to avoid the inflation rising again. What this will do is create a credit crunch in India while at the same time money is going to be pumped in the US due to lower interest rates. The foreign investors will prefer the promising Indian market over the unpredictable and slowing US market. At the same time due to a decrease in the interest rates in the US, the liquidity from the ‘Yen carry trade’ (People borrow money in Yen at extremely low interest rate of .25% and lend/invest in high interest rate US market to earn the difference in interests) may be directed to the developing economies like India. This will cause further problems for government economists who are already clueless on how to control the credit flow in Indian market without hampering the growth rate.

The subprime market has already caused the US dollar to depreciate as compared to other currencies (including the Rupee). The imports are going to be cheaper and the inflation will be pushed down by an appreciating rupee which is good for the country. But the $ depreciation is bad for Indian export industry, specially the Indian IT and BPO/KPO industries. Also the US firms in other sectors having operations in India will find the cost advantage of India getting nullified causing job and salary cuts. The solution to this problem is to increase the efficiency and cost effectiveness of these companies which will offset the depreciating dollar.

Conclusion: On the whole the Indian market seems fairly immune to the US subprime meltdown due to unavailability of US mortgage securities to Indian banks. The slowdown in the US economy and the possibility of a recession will have effects as the complete decoupling of Indian markets is still just hypothetical. But the effects are going to be minimal. However the markets will tend to remain volatile due to many more reasons that will be discussed in the subsequent write-ups.

-Mayank

2/2/2008

The Subprime market meltdown

"Subprime" has been the buzzword (nightmare for some) in financial circles since the start of year 2007. What makes this topic really important is the huge impact on US economy and hence the world economy (will discuss this relationship later).

What is Subprime? Subprime literally means 'relating to (or for) people with a poor credit rating', that is for people who have been defaulters in the past or who don't have enough healthy assets to keep as mortgage with the lenders. These people cannot procure money from the prime market.

A market is called subprime market when the money lenders give money to people without verifying their credit rating but at higher rate of interest (than the prime market) in order to earn greater profits. In the early part of this decade, the U.S. economy was doing well and people had cash and the will to spend. Also the positive feeling in the financial industry (also known as the Wall Street) and a rosy picture of the US land market by rating agencies was a boost for property market and the associated bonds. Hence people were ready to spend more than they could possibly earn and so procured loans from banks and other firms. The property rates in U.S. were increasing at a fast rate and no one wanted to miss the opportunity. People took multiple loans from subprime markets keeping (inflated) property as mortgages to invest further in house market thus increasing the property prices even more. They were happy as they could see their investment soaring and making money for them.

How did the crisis start? The subprime crisis surfaced when people started defaulting on the loans. This was inevitable because these loans were given without proper checks to people without jobs or assets. The banks confiscated their houses and started looking for buyers to recover the money. When this started happening, it triggered a vicious circle. Now people were not finding it easy to get loans as easily as before and so there were few buyers in the inflated property market. Thus the prices started falling (less demand and more supply). The decrease in the property rates meant a decrease in the value of the houses owned by borrowers and hence that of mortgaged houses with the lenders. There were more defaulters pulling the property rates further down (a decrease of more than 8% average) hurting the market even more.

How did the subprime meltdown spread and gain such big proportion? The banks who gave money to the mortgage lenders and bought these loans were supposed to scrutinize the loans. But they did not care about late payments and early defaulters as the risk was divided among investors through the sale of resulting bonds and securities that were sold to investment firms, hedge funds, mutual funds, etc. by the banks. (The securities are called RMBS-Residential Mortgage Based Securities which are further sold as CDO-Collateral Debt Obligation).

The participation of investment banks, hedge funds and mutual funds in subprime mortgage led to a spread of the losses among the investors which resulted in a credit crunch in the US market. Investors started loosing faith in the market and went on a frenetic selling spree leading to a drop in the share prices of almost all the sectors. Thus money has been sucked out of the US market and this credit crunch is the reason why experts are predicting a recession in the whole US economy. Big investment banks and lenders have subprime writedowns in Billions of dollars. The worst-hit so far are Citigroup and UBS. Goldman Sachs and Lehman brothers are the rated investment banks with minimal presence in the subprime mortgage market (as of now) and are speculated to be eying this meltdown as a good investment opportunity (this it self can be discussed at length).

What is being done to contain the damage? The Federal Reserve (America's central bank) has been trying its best to avoid a full blown recession by decreasing the interest rate at a pace unprecedented in its history. The latest cut was been done as recently as 30th Jan by 0.5 % points to reduce the interest rate to 3% (the short term interest rate has fallen by 2.25% since Aug 07) in order to avoid credit crunch and provide liquidity in this time of crisis. However there is lot of uncertainty among the investors as they don't know who is involved in the subprime mortgage market and the investment banks themselves are not very clear about how deep they are in this crisis. The rating agencies have rated the mortgage related securities/bonds at abysmally low value and thus the prices are depreciating with no buyers. It will take at least three more quarters to understand the full extent of the subprime crisis.

-Mayank